**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| ** ** | ** ** | **(Mark One)**                                                                                          |
|------------|------------|---------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                              |
| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** ** | ** ** | ** **                                                                                              |
| ** ** | ** ** | **For the quarterly period ended December 31,  2008**                                              |
| ** ** | ** ** | ** **                                                                                              |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom                  to                  **

 

**Commission file number 001-32496**

 

**CANOPETROLEUM, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**The Burnett Plaza**

**801 Cherry Street, Suite 3200**

**Fort Worth, TX 76102**

(Address of principal executive offices, including zip code)

 

**(817) 698-0900**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  x    No  o

 

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

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

 

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

 

Statethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:  46,078,518 shares of commonstock, $0.0001 par value per share, as of February 6, 2009.

 

 

 

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**PART I — FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED BALANCE SHEETS**

(Unaudited)

 
| ** **                                                                                                                                                                                                                                                                                                                                         | ** ** | **December 31,** | ** **  | **June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|-------------------|------------|
| **In Thousands, Except  Shares and Per Share Amounts**                                                                                                                                                                                                                                                                                             | ** ** | **2008**              | ** **  | **2008**          | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                                                                                                       | ** ** | ** **            | ** **  | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                                                                                                 | ** ** | ** **            | ** **  | ** **        | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                                          |       | $                     | 668         |              | $          | 771 |   |
| Accounts receivable                                                                                                                                                                                                                                                                                                                                |       | 2,196                 |        | 3,916             |       |
| Deferred tax asset                                                                                                                                                                                                                                                                                                                                 |       | —                |        | 3,592             |       |
| Derivative assets                                                                                                                                                                                                                                                                                                                                  |       | 7,967                 |        | —            |       |
| Inventory and other current assets                                                                                                                                                                                                                                                                                                                 |       | 1,341                 |        | 642               |       |
| Assets held for sale (Note 2)                                                                                                                                                                                                                                                                                                                      |       | —                |        | 25,912            |       |
| Total current assets                                                                                                                                                                                                                                                                                                                               |       | 12,172                |        | 34,833            |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |        |              |       |
| **Oil and gas properties****,**successful efforts method                                                                                                                                                                                                                                                                                           |       | 282,348               |        | 247,930           |       |
| Less accumulated depletion and depreciation                                                                                                                                                                                                                                                                                                        |       | (32,743               | )           | (7,962            | )          |
| Net oil and gas properties                                                                                                                                                                                                                                                                                                                         |       | 249,605               |        | 239,968           |       |
| Fixed assets and other, net                                                                                                                                                                                                                                                                                                                        |       | 2,820                 |        | 2,096             |       |
| Derivative assets                                                                                                                                                                                                                                                                                                                                  |       | 6,164                 |        | 125               |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                           |       | 101                   |        | 786               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                                                                                   | ** ** | **$**                 | **270,862** | ** **        | **$**      | **277,808** | ** ** |
| ***LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                                                                                  |       |                  |        |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                                                                                            |       |                  |        |              |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                   |       | $                     | 7,252       |              | $          | 8,679 |   |
| Accrued liabilities                                                                                                                                                                                                                                                                                                                                |       | 7,069                 |        | 2,840             |       |
| Deferred tax liabilities                                                                                                                                                                                                                                                                                                                           |       | 2,890                 |        | —            |       |
| Liabilities associated with discontinued  operations (Note 2)                                                                                                                                                                                                                                                                                      |       | —                |        | 1,398             |       |
| Oil and gas sales payable                                                                                                                                                                                                                                                                                                                          |       | 558                   |        | 815               |       |
| Derivative liabilities                                                                                                                                                                                                                                                                                                                             |       | —                |        | 9,978             |       |
| Current portion of asset retirement  obligations                                                                                                                                                                                                                                                                                                   |       | 336                   |        | 345               |       |
| Total current liabilities                                                                                                                                                                                                                                                                                                                          |       | 18,105                |        | 24,055            |       |
| **Long-term liabilities**                                                                                                                                                                                                                                                                                                                          |       |                  |        |              |       |
| Long-term debt (Note 4)                                                                                                                                                                                                                                                                                                                            |       | 30,000                |        | 73,500            |       |
| Asset retirement obligations                                                                                                                                                                                                                                                                                                                       |       | 3,000                 |        | 2,865             |       |
| Deferred litigation credit (Note 13)                                                                                                                                                                                                                                                                                                               |       | —                |        | 6,000             |       |
| Derivative liabilities                                                                                                                                                                                                                                                                                                                             |       | —                |        | 16,390            |       |
| Deferred tax liabilities                                                                                                                                                                                                                                                                                                                           |       | 30,147                |        | 26,062            |       |
| Total liabilities                                                                                                                                                                                                                                                                                                                                  |       | 81,252                |        | 148,872           |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |        |              |       |
| **Temporary equity**                                                                                                                                                                                                                                                                                                                               |       |                  |        |              |       |
| Series D convertible preferred stock and  paid-in-kind dividend; par value $.0001 per share, stated value $1,000 per  share; 49,116 shares authorized; 23,849 and 44,474 shares issued at December  31, 2008 and June 30, 2008, respectively; liquidation preference at December  31, 2008 and June 30, 2008 of $26,431 and $48,353, respectively. |       | 24,848                |        | 45,086            |       |
|                                                                                                                                                                                                                                                                                                                                               |       |                  |        |              |       |
| **Commitments and contingencies (Note 13)**                                                                                                                                                                                                                                                                                                        |       |                  |        |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                                                                                                      |       |                  |        |              |       |
| Common stock, par value $.0001 per share;  100,000,000 authorized; 47,346,812 and 46,078,518 shares issued and  outstanding at December 31, 2008, respectively; and40,523,168 and  39,254,874 shares issued and outstanding at June 30, 2008, respectively.                                                                                        |       | 5                     |        | 4                 |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                         |       | 188,161               |        | 121,831           |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                |       | (22,833               | )           | (37,414           | )          |
| Treasury stock, at cost; 1,268,294 shares  held in escrow                                                                                                                                                                                                                                                                                          |       | (571                  | )           | (571              | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                                                    |       | 164,762               |        | 83,850            |       |
| **TOTAL LIABILITIES, TEMPORARY EQUITY AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                             | ** ** | **$**                 | **270,862** | ** **        | **$**      | **277,808** | ** ** |

 

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

 

2

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                       | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| **In Thousands, Except Per Share Data** | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Operating Revenues:**                                          | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil sales                                                  |       | $                                | 3,685      |                           | $          | 4,855 |   | $ | 11,803 |   | $ | 8,912 |   |
| Natural gas sales                                                |       | 1,112                            |       | 2,762                          |       | 3,846 |   | 5,212 |   |
| Other revenue                                                    |       | 79                               |       | 79                             |       | 159 |   | 158 |   |
| Total operating revenues                                         |       | 4,876                            |       | 7,696                          |       | 15,808 |   | 14,282 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Operating Expenses:**                                          |       |                             |       |                           |       |   |   |   |   |
| Lease operating                                                  |       | 4,774                            |       | 2,659                          |       | 9,843 |   | 5,226 |   |
| Production and ad valorem taxes                                  |       | 426                              |       | 488                            |       | 1,479 |   | 981 |   |
| General and administrative                                       |       | 9,544                            |       | 3,763                          |       | 14,404 |   | 7,385 |   |
| Impairment of long-lived assets (Note 12)                        |       | 22,398                           |       | —                         |       | 22,398 |   | — |   |
| Depletion and depreciation                                       |       | 1,361                            |       | 891                            |       | 2,572 |   | 1,752 |   |
| Accretion of discount on asset retirement  obligations           |       | 76                               |       | 50                             |       | 150 |   | 101 |   |
| Total operating expenses                                         |       | 38,579                           |       | 7,851                          |       | 50,846 |   | 15,445 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Loss from operations**                                         |       | (33,703                          | )          | (155                           | )          | (35,038 | ) | (1,163 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Other income (expense):**                                      |       |                             |       |                           |       |   |   |   |   |
| Interest expense and other                                       |       | (119                             | )          | (151                           | )          | (254 | ) | (352 | ) |
| Impairment of goodwill                                           |       | (685                             | )          | —                         |       | (685 | ) | — |   |
| Unrealized gain (loss) on commodity  derivatives                 |       | 18,933                           |       | (1,846                         | )          | 43,180 |   | (2,362 | ) |
| Realized gain (loss) on commodity  derivatives                   |       | 2,365                            |       | (38                            | )          | 1,814 |   | 259 |   |
| Total other income (expense)                                     |       | 20,494                           |       | (2,035                         | )          | 44,055 |   | (2,455 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Income (loss) from continuing operations  before income taxes    |       | (13,209                          | )          | (2,190                         | )          | 9,017 |   | (3,618 | ) |
| Deferred income tax benefit (expense)                            |       | 4,581                            |       | 778                            |       | (4,038 | ) | 1,275 |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Income (loss) from continuing operations                         |       | (8,628                           | )          | (1,412                         | )          | 4,979 |   | (2,343 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Income from discontinued operations, net of  related taxes       |       | 12,246                           |       | 722                            |       | 11,393 |   | 1,374 |   |
| **Net income (loss)**                                            |       | 3,618                            |       | (690                           | )          | 16,372 |   | (969 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| Preferred stock dividend                                         |       | (855)                            |       | (888)                          |       | (1,791) |   | (1,855) |   |
| Preferred stock repurchased in excess of  carrying amount        |       | 10,890                           |       | —                         |       | 10,890 |   | — |   |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Net income (loss) applicable to common  stock**                |       | $                                | 13,653     |                           | $          | (1,578 | ) | $ | 25,471 |   | $ | (2,824 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Net income (loss) per share - basic**                          |       |                             |       |                           |       |   |   |   |   |
| Continuing operations                                            |       | $                                | 0.03       |                           | $          | (0.06 | ) | $ | 0.31 |   | $ | (0.12 | ) |
| Discontinued operations                                          |       | 0.27                             |       | 0.02                           |       | 0.25 |   | 0.04 |   |
| **Net income (loss) per share - basic (Note  9)**                |       | $                                | 0.30       |                           | $          | (0.04 | ) | $ | 0.56 |   | $ | (0.08 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Net income (loss) per share - diluted**                        |       |                             |       |                           |       |   |   |   |   |
| Continuing operations                                            |       | $                                | 0.04       |                           | $          | (0.06 | ) | $ | 0.30 |   | $ | (0.12 | ) |
| Discontinued operations                                          |       | 0.23                             |       | 0.02                           |       | 0.21 |   | 0.04 |   |
| **Net income (loss) per share - diluted (Note  9)**              |       | $                                | 0.27       |                           | $          | (0.04 | ) | $ | 0.51 |   | $ | (0.08 | ) |
|                                                             |       |                             |       |                           |       |   |   |   |   |
| **Weighted average common shares outstanding**                   |       |                             |       |                           |       |   |   |   |   |
| Basic                                                            |       | 45,422                           |       | 35,101                         |       | 45,380 |   | 33,859 |   |
| Diluted                                                          |       | 53,275                           |       | 35,101                         |       | 53,743 |   | 33,859 |   |

 

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

 

3

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**CANO PETROLEUM, INC.**

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

**JULY 1, 2008 THROUGH DECEMBER 31, 2008****(Unaudited)**

 
| ** **                                                   | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **              | ** ** | ** ** | ** **  | ** ** | ** **    | ** ** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------------|------------|------------|-------------|------------|---------------|------------|------------|
| ** **                                                   | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **  |
| **Dollar Amounts in Thousands**               | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares** | ** **  | **Amount** | ** **    | **Total**  | ** ** |
| **Balance at June 30, 2008**                                 | ** ** | **40,523,168**        | ** ** | **$**       | **4**      | ** **      | **$**      | **121,831**             | ** ** | **$**      | **(37,414** | **)**      | **1,268,294** | ** ** | **$**      | **(571** | **)** | **$** | **83,850** | ** ** |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Net proceeds from issuance of common shares  on July 1, 2008 |       | 7,000,000             |       | 1           |       | 53,907          |       | —                  |       | —     |        | —     |          | 53,908     |       |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Forfeiture and surrender of restricted  stock                |       | (176,356              | )          | —      |       | (228            | )          | —                  |       | —     |        | —     |          | (228       | )          |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Stock-based compensation                                     |       | —                |       | —      |       | 1,761           |       | —                  |       | —     |        | —     |          | 1,761      |       |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Preferred stock dividend                                     |       | —                |       | —      |       | —          |       | (1,791                  | )          | —     |        | —     |          | (1,791     | )          |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Preferred stock repurchased in excess of  carrying amount    |       | —                |       | —      |       | 10,890          |       | —                  |       | —     |        | —     |          | 10,890     |       |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| Net income                                                   |       | —                |       | —      |       | —          |       | 16,372                  |       | —     |        | —     |          | 16,372     |       |
|                                                         |       |                  |       |        |       |            |       |                    |       |       |        |       |          |       |       |
| **Balance at December 31, 2008**                             | ** ** | **47,346,812**        | ** ** | **$**       | **5**      | ** **      | **$**      | **188,161**             | ** ** | **$**      | **(22,833** | **)**      | **1,268,294** | ** ** | **$**      | **(571** | **)** | **$** | **164,762** | ** ** |

 

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

 

4

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                            | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                            | ** ** | **December 31,**          | ** ** |
| **In Thousands**                                                                                 | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| **Cash flow from operating activities:**                                          | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                     |       | $                              | 16,372     |   | $ | (969 | ) |
| Adjustments needed to reconcile net income  (loss) to net cash flow provided by (used in) operations: |       |                           |       |   |   |
| Unrealized loss (gain) on commodity  derivatives                                                      |       | (43,180                        | )          | 2,362 |   |
| Gain on sale of oil and gas properties                                                                |       | (19,309                        | )          | 76 |   |
| Accretion of discount on asset retirement  obligations                                                |       | 153                            |       | 108 |   |
| Depletion and depreciation                                                                            |       | 2,587                          |       | 2,287 |   |
| Impairment of long-lived assets oil &  gas properties                                             |       | 25,914                         |       | — |   |
| Impairment of goodwill                                                                                |       | 685                            |       | — |   |
| Stock-based compensation expense                                                                      |       | 1,761                          |       | 1,660 |   |
| Deferred income tax expense (benefit)                                                                 |       | 10,567                         |       | (502 | ) |
| Amortization of debt issuance costs and  prepaid expenses                                             |       | 713                            |       | 648 |   |
|                                                                                                  |       |                           |       |   |   |
| Changes in assets and liabilities relating  to operations:                                            |       |                           |       |   |   |
| Restricted cash                                                                                       |       | —                         |       | 3,182 |   |
| Accounts receivable                                                                                   |       | 2,578                          |       | 1,214 |   |
| Derivative assets                                                                                     |       | 1,882                          |       | (291 | ) |
| Inventory and other current assets                                                                    |       | (1,216                         | )          | (549 | ) |
| Accounts payable                                                                                      |       | (721                           | )          | (1,788 | ) |
| Accrued liabilities                                                                                   |       | (1,554                         | )          | (37 | ) |
| Oil and gas sales payable                                                                             |       | (373                           | )          | 106 |   |
| **Net cash provided by (used in) operations**                                                         | ** ** | **(3,141**                     | **)**      | **7,507** | ** ** |
|                                                                                                  |       |                           |       |   |   |
| **Cash flow from investing activities:**                                                              |       |                           |       |   |   |
| Additions to oil and gas properties, fixed  assets and other                                          |       | (35,982                        | )          | (39,872 | ) |
| Proceeds from sale of oil and gas  properties                                                         |       | 40,667                         |       | — |   |
| **Net cash provided by (used in) investing  activities**                                              | ** ** | **4,685**                      | ** ** | **(39,872** | **)** |
|                                                                                                  |       |                           |       |   |   |
| **Cash flow from financing activities:**                                                              |       |                           |       |   |   |
| Repayments of long-term debt                                                                          |       | (73,500                        | )          | — |   |
| Borrowings of long-term debt                                                                          |       | 30,000                         |       | 8,500 |   |
| Payments for debt issuance costs                                                                      |       | (916                           | )          | — |   |
| Proceeds from issuance of common stock, net                                                           |       | 53,908                         |       | 23,823 |   |
| Repurchases of preferred stock                                                                        |       | (10,377                        | )          | — |   |
| Payment of preferred stock dividend                                                                   |       | (762                           | )          | (1,223 | ) |
| **Net cash provided by (used in) financing  activities**                                              | ** ** | **(1,647**                     | **)**      | **31,100** | ** ** |
|                                                                                                  |       |                           |       |   |   |
| Net decrease in cash and cash equivalents                                                             |       | (103                           | )          | (1,265 | ) |
| Cash and cash equivalents at beginning of  period                                                     |       | 771                            |       | 2,119 |   |
| **Cash and cash equivalents at end of period**                                                        | ** ** | **$**                          | **668**    | ** ** | **$** | **854** | ** ** |
|                                                                                                  |       |                           |       |   |   |
| **Supplemental disclosure of noncash  transactions:**                                                 |       |                           |       |   |   |
| Payments of preferred stock dividend in  kind                                                         |       | $                              | 1,029      |   | $ | 1,066 |   |
| Preferred stock repurchased in excess of  carrying amount                                             |       | $                              | 10,890     |   | $ | — |   |
| Common stock issued for preferred stock  conversion                                                   |       | $                              | —     |   | $ | 4,000 |   |
|                                                                                                  |       |                           |       |   |   |
| **Supplemental disclosure of cash  transactions:**                                                    |       |                           |       |   |   |
| Cash paid during the period for interest                                                              |       | $                              | 815        |   | $ | 1,779 |   |

 

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

 

5

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**CANO PETROLEUM, INC.**

**NOTES TO FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

 

The interim consolidated financial statementsof Cano Petroleum, Inc. are unaudited and contain all adjustments. Theadjustments consist primarily of normal recurring accruals and items unusual toour normal business activities related to litigation accruals and impairment chargesnecessary for a fair statement of the results for the interim periodspresented. Results for interim periods are not necessarily indicative ofresults to be expected for a full year due in part, but not limited to, thevolatility in prices for crude oil and natural gas, future commodity prices forcommodity derivatives, interest rates, estimates of reserves, drilling risks,geological risks, transportation restrictions, the timing of acquisitions,product demand, market competition, interruption in production, our ability toobtain additional capital, and the success of waterflooding and enhanced oilrecovery techniques. You should read these consolidated interim financialstatements in conjunction with the audited consolidated financial statementsand notes thereto included in our Form 10-K for the year ended June 30,2008.

 

The accompanyingfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) andinclude the accounts of Cano and its wholly-owned subsidiaries. Intercompanyaccounts and transactions are eliminated. In preparing the accompanyingfinancial statements, management has made certain estimates and assumptionsthat affect reported amounts in the financial statements and disclosures ofcontingencies. Actual results may differ from those estimates. Significantassumptions are required in the valuation of proved oil and natural gasreserves, which may affect the amount at which oil and natural gas propertiesare recorded. The computation of stock-based compensation expense requiresassumptions such as volatility, expected life and the risk-free interestrate.  The computation of themark-to-market valuation of our commodity derivatives includes theobservability of quoted market prices and an assessment of the potentialnon-performance of the counterparties. It is at least reasonably possible theseestimates could be revised in the near term, and these revisions could bematerial.

 

***New Accounting Pronouncements***

 

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

 

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

 

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

 

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adopt SFAS No. 161 on July 1, 2009. We do not expect theadoption of this statement to have a material impact on our financial position,results of operations or cash flows.

 

InDecember 2008, the FASB issued EITF********07-5, *Determining Whether anInstrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock* (“EITF 07-5”).  EITF07-5 affects companies that have provisions in their securities purchaseagreements (for warrants and convertible instruments) that resetissuance/conversion prices based upon new issuances by companies at pricesbelow the exercise price of said instrument. Warrants and convertible instruments with such provisions will requirethe embedded derivative instrument to be bifurcated and separately accountedfor as a derivative under SFAS No. 133. Subject to certain exceptions, our Series D convertible preferredstock provides for resetting the conversion price if we issue new common stockbelow $5.75 per share.  We are evaluatingthe effect of EITF 07-5 on ourfinancial position, results of operations or cash flows.  We will adopt EITF 07-5 on July 1, 2009.

 

**2.    DISCONTINUEDOPERATIONS**

 

On October 1, 2008,we completed the sale of our wholly-owned subsidiary, Pantwist, LLC, for a netpurchase price of $40.0 million consisting of a $42.7 million purchase priceadjusted for $2.1 million of net cash received from discontinued operatingincome during the three months ended September 30, 2008 and $0.6 millionof advisory fees.  The sale had an effectivedate of July 1, 2008.  At October 1, 2008, we recorded a pre-taxgain associated with the sale, exclusive of discontinued operating income, ofapproximately $19.2 million ($12.2 million after-tax). All current taxliabilities associated with such gain were offset by our existing net operatinglosses. We used the entire $42.1 million net cash proceeds received from thetransaction and cash on hand to pay down amounts outstanding under our seniorcredit agreement on October 1, 2008.

 

On December 2, 2008,we sold our interests in our Corsicana oil and gas properties (“CorsicanaProperties”) for $0.3 million.  For thethree and six months ended December 31, 2008, the net operating losses forthe Corsicana Properties amounted to $31,000 pre-tax ($20,000 after-tax) and$3.6 million pre-tax ($2.3 million after-tax), respectively. In the quarterended September 30, 2008, we recorded a $3.5 million ($2.3 millionafter-tax) impairment at Corsicana, as we determined that we would not bedeveloping its proved undeveloped reserves within the next five years sincereserves that are not going to be developed in the next five years cannot beincluded as proved undeveloped reserves.

 

The operating results ofPantwist, LLC and our Corsicana Properties for the three and six months ended December 31,2008 and 2007 have been reclassified as discontinued operations in theconsolidated statements of operations as detailed in the table below.

 

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| ** **                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| ** **                                | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Operating Revenues:                       |       |                             |       |                           |       |   |   |   |   |
| Crude oil sales                           |       | $                                | 10         |                           | $          | 1,018 |   | $ | 1,321 |   | $ | 1,957 |   |
| Natural gas sales                         |       | —                           |       | 1,305                          |       | 1,696 |   | 2,501 |   |
| Total operating revenues                  |       | 10                               |       | 2,323                          |       | 3,017 |   | 4,458 |   |
| Operating Expenses:                       |       |                             |       |                           |       |   |   |   |   |
| Lease operating                           |       | 31                               |       | 525                            |       | 633 |   | 1,061 |   |
| Production and ad valorem taxes           |       | —                           |       | 267                            |       | 197 |   | 473 |   |
| Impairment of long-lived assets           |       | —                           |       | —                         |       | 3,516 |   | — |   |
| Depletion and depreciation                |       | 8                                |       | 261                            |       | 15 |   | 535 |   |
| Accretion of discount on asset retirement |       | 1                                |       | 4                              |       | 3 |   | 7 |   |
| Interest expense, net                     |       | —                           |       | 62                             |       | 34 |   | 158 |   |
| Total operating expenses                  |       | 40                               |       | 1,119                          |       | 4,398 |   | 2,234 |   |
| Gain (loss) on sale of properties         |       | 19,303                           |       | (76                            | )          | 19,309 |   | (76 | ) |
| Income before income taxes                |       | 19,273                           |       | 1,128                          |       | 17,928 |   | 2,148 |   |
| Income tax provision                      |       | (7,027                           | )          | (406                           | )          | (6,535 | ) | (774 | ) |
| Income from discontinued operations       |       | $                                | 12,246     |                           | $          | 722 |   | $ | 11,393 |   | $ | 1,374 |   |

 

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

 

**3.    COMMONSTOCK ISSUANCE**

 

On July 1, 2008, wecompleted the sale of 7,000,000 shares of our common stock through anunderwritten offering at a share price of $8.00 per share ($7.75 net to us)resulting in net proceeds of approximately $53.9 million afterunderwriting discounts, commissions and expenses. We used the net proceeds fromthe offering to pay down debt which will be subsequently drawn in order tofinance (i) development activities, (ii) general corporate purposes,and (iii) selective acquisitions.

 

**4.    LONG-TERMDEBT**

 

At December 31, 2008 and June 30,2008, the outstanding amount due under our credit agreements was$30.0 million and $73.5 million, respectively.  The $30.0 million wasborrowed solely from our senior credit agreement which had an average interestrate of 3.30% at December 31, 2008. Our sources of long-term debt areour senior credit facility (current borrowing base of $60.0 million) and oursubordinated credit agreement ($15.0 million availability), which are discussedin greater detail below.

 

*SeniorCredit Agreement*

 

On December 17, 2008, we finalized a new$120.0 million Amended and Restated Credit Agreement (“ARCA”) with Union Bankof North America, N.A. (“UBNA,” f/k/a Union Bank of California, N.A.) andNatixis. UBNA is the Administrative Agent and Issuing Lender of the ARCA. The initial and current borrowing base, based upon our proved reserves, is$60.0 million.  Pursuant to the terms of the ARCA, the borrowing base isto be redetermined at May 1, 2009 and again at June 30, 2009.  Thereafter, there will be a redeterminationevery six months with one interim, additional redetermination allowed duringany six month period between scheduled redeterminations.

 

At our option, interest is either (i) thesum of (a) the UBNA reference rate and (b)  the applicable margin of (1) 0.875%if less than 50% of the borrowing base is borrowed, (2) 1.125% if at least50% but less than 75% of 

 

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the borrowing base is borrowed, (3) 1.375% if at least 75% butless than 90% of the borrowing base is borrowed or (4) 1.625% if at least90% of the borrowing base is borrowed; or (ii) the sum of (a) theone, two, three, six, nine or twelve month LIBOR rate (at our option) and (b) theapplicable margin of (1) 2.0% if less than 50% of the borrowing base isborrowed, (2) 2.25% if at least 50% but less than 75% of the borrowingbase is borrowed, (3) 2.50% if at least 75% but less than 90% of theborrowing base is borrowed or (4) 2.75% if at least 90% of the borrowingbase is borrowed.  We owe a commitment fee on the unborrowed portion ofthe borrowing base of 0.375% per annum if less than 90% of the borrowing baseis borrowed and 0.50% per annum if at least 90% of the borrowing base isborrowed.

 

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

 

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

 

We must meet certain financial ratios. The ratio of current assets to current liabilities must not be less than 1.00to 1.00 for each fiscal quarter.  Current assets include unused borrowingbase under the ARCA and the availability under the Subordinated CreditAgreement (as defined below).  Currentliabilities exclude current portions of debt other than any current debtrelating to the Series D Convertible Preferred Stock and liabilities forasset retirement obligations.  Currentassets and current liabilities exclude derivative assets and liabilities. The ratio of consolidated debt to consolidated EBITDA for the trailing fourfiscal quarter period then ended must not be greater than 4.00 to 1.00. For the purposes of this ratio, debt does not include the amounts of our Series DConvertible Preferred Stock.  The ratio of consolidated EBITDA for theprevious four fiscal quarters to consolidated interest expense for the previousfour fiscal quarters must not be less than 3.00 to 1.00.  Through thequarter-ending September 30, 2009, for both ratios, EBITDA includes thenet gain on the sale of Pantwist LLC on October 1, 2008. At December 31,2008, we were in compliance with the senior credit agreement debt covenants.

 

*Subordinated Credit Agreement*

 

On September 30, 2008, we paid off theentire outstanding $15.0 million principal due under the then existingsubordinated credit agreement, interest expense and a prepayment premium of$0.3 million.  In conjunction with thepayoff, we terminated that subordinated credit agreement.

 

On December 17, 2008, we finalized a new$25.0 million Subordinated Credit Agreement among Cano, the lenders andUnionBanCal Equities, Inc (“UBE”) as Administrative Agent (the “SubordinatedCredit Agreement”).  The current availability under the SubordinatedCredit Agreement is $15.0 million.  An additional $10.0 million could bemade available at the lenders’ sole discretion.  Any advances, under the$15.0 million currently available must be made by March 17, 2009. Any amounts borrowed shall be used to pay down debt outstanding pursuant to theARCA, for capital expenditures, for working capital and for general corporatepurposes

 

The interest rate is the sum of (a) theone, two, three, six, nine or twelve month LIBOR rate (at our option) and (b) 6.0%. Through March 17, 2009, Cano owes a commitment fee of 1.0% on theunborrowed portion of 

 

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the available borrowing amount.  As of December 31, 2008, noamounts are borrowed under the Subordinated Credit Agreement.

 

Unless specific events of default occur, thematurity date is June 17, 2013.  Specific events of default whichcould cause all outstanding principal and accrued interest to be accelerated,include, but are not limited to, payment defaults, material breaches ofrepresentations and warranties, breaches of covenants, certain cross-defaults,insolvency, a change in control or a material adverse change.

 

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

 

We must meet certain financial ratios. The ratio of current assets to current liabilities must not be less than 1.00to 1.00 for each fiscal quarter.  Current assets include the unusedborrowing base under the ARCA and the availability under the SubordinatedCredit Agreement.  Current liabilitiesexclude current portions of debt other than any current debt relating to the Series DConvertible Preferred Stock and liabilities for asset retirementobligations.  Current assets and currentliabilities exclude derivative assets and liabilities.  The ratio ofconsolidated debt to consolidated EBITDA for the trailing four fiscal quarterperiod then ended must not be greater than 4.50 to 1.00.  For the purposesof this ratio, debt does not include the amounts of our Series DConvertible Preferred Stock.  The ratio of consolidated EBITDA for theprevious four fiscal quarters to consolidated interest expense for the previousfour fiscal quarters must not be less than 2.50 to 1.00.  Through thequarter-ending September 30, 2009, for both ratios, EBITDA includes thenet gain on the sale of Pantwist LLC on October 1, 2008. The ratio oftotal present value to consolidated debt must not be less than 1.50 to1.00.  Total present value is the sum of 100% of the net present value,discounted at 10% per annum, of the future net revenues expected to accrue to (i) PDPreserves, (ii) PDNP reserves and (iii) PUD reserves, with the totalpresent value of PDP reserves being at least 60% of the aggregate total presentvalue.

 

*InterestRate Swap Agreement*

 

On January 12, 2009, we entered into athree-year LIBOR interest rate basis swap contract with Natixis FinancialProducts, Inc. (“Natixis FPI”) for $20.0 million in notionalexposure.  Under the terms of the transaction, we will pay Natixis FPI, inthree-month intervals, a fixed rate of 1.73% and Natixis FPI will pay Cano theprevailing three-month LIBOR rate.  We donot designate this interest rate swap contract as either a cash flow or fairvalue hedge.

 

**5.    COMMODITYDERIVATIVES**

 

Pursuant to our seniorand subordinated credit agreements discussed in Note 4, we are required tomaintain our existing commodity derivative contracts, all of which have UBNA asour counterparty.  We have no obligationto enter into commodity derivative contracts in the future. Should we choose toenter into commodity derivative contracts to mitigate future price risk, wecannot enter into contracts for greater than 85% of our crude oil and naturalgas production volumes attributable to proved producing reserves.  As of December 31, 2008, we maintain thefollowing commodity derivative contracts:

 

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

 

During October 2008,we sold certain uncovered “floor price” commodity derivative contracts for theperiod July 2010 to December 2010 for $0.6 million to ourcounterparty and realized a gain of $0.1 million.  During November 2008, we sold allremaining uncovered “floor price” commodity derivative contracts for the periodNovember 2008 through June 2010 for $2.6 million to our counterpartyand realized a gain of $0.6 million.

 

During the three and sixmonths ended December 31, 2008 and 2007, there were settlements under ourcommodity derivatives, due to us and paid by us, that are accrued as realizedgains or losses on commodity derivatives in our consolidated statements ofoperations that are summarized as follows:

 
| ** **                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                        | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| **In Thousands**                                             | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Settlements received / accrued - monthly                          |       | $                                | 1,712      |                           | $          | 176 |   | $ | 1,712 |   | $ | 473 |   |
| Settlements received - sale of “floor  price” contracts |       | 653                              |       | —                         |       | 653 |   | — |   |
| Settlements paid / accrued - monthly                              |       | —                           |       | (214                           | )          | (551 | ) | (214 | ) |
| Realized gain (loss) on commodity  derivatives                    |       | $                                | 2,365      |                           | $          | (38 | ) | $ | 1,814 |   | $ | 259 |   |

 

The cash settlements received/accruedby us were cumulative monthly payments due to us since the NYMEX natural gasand crude oil prices were lower than the “floor prices” set for the respectivetime periods and realized gains from the sale of uncovered “floor price”contracts as previously discussed. The cash settlements paid/accrued by us werecumulative monthly payments due to our counterparty since the NYMEX crude oiland natural gas prices were higher than the “ceiling prices” set for therespective time periods. The cash flows relating to the derivative instrumentsettlements that are due, but not cash settled are reflected in operatingactivities on our consolidated statements of cash flows. At December 31,2008, we had recorded a $0.9 million receivable from our counterparty includedin accounts receivable on our consolidated balance sheet. At June 30,2008, we had recorded a $1.2 million payable to our counterparty included inaccounts payable on our consolidated balance sheet.

 

We compute our commodityderivative contracts mark-to-market valuation based on assumptions of forwardprices, volatility and the time value of money as discussed in Note 11. Wecompared our valuation to our counterparties’ independently derived valuationto further validate our mark-to-market valuation. During the three months endedDecember 31, 2008, we recognized an unrealized gain on commodityderivatives in our consolidated statements of operations amounting to$18.9 million as compared to an unrealized loss on commodity derivativesof $1.8 million for the three months ended December 31, 2007.  During the six months ended December 31,2008, we recognized an unrealized gain on commodity derivatives in ourconsolidated statements of operations amounting to $43.2 million ascompared to an unrealized loss on commodity derivatives of $2.4 million for thesix months ended December 31, 2007.

 

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As of December 31,2008, we had aggregate derivative assets of $14.1 million.  These amounts are based on our mark-to-marketvaluation of our commodity derivatives at December 31, 2008 and may not beindicative of actual future cash settlements.

 

**6.****    ****PREFERRED STOCK REPURCHASE**

 

During November and December 2008, werepurchased 22,948 shares of Series D Convertible Preferred Stock,including accrued dividends and 2,323 shares from paid-in kind (“PIK”)dividends for approximately $10.4 million.    At December 31,2008, 26,431 shares of Series D Convertible Preferred Stock remainoutstanding (including 2,582 shares from PIK dividends).

 

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

 

As of December 31, 2008, we have non-vestedrestricted shares totaling 656,667 shares to key employees pursuant to our 2005Long-Term Incentive Plan, as summarized below:

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

 

The restricted share grants vest based on futureyears of service ranging from one to three years depending on the life of theaward.  The fair value is based on our actual stock price on the date ofgrant multiplied by the number of restricted shares granted.  As of December 31,2008, the fair value attributed to non-vested restricted shares amounted to$4.6 million.  For the quarters ended December 31, 2008 and 2007, wehave expensed $0.5 million and $0.4 million, respectively, to stockcompensation expense based on amortizing the fair value of prior grants overtheir appropriate service period.  Forthe six months ended December 31, 2008 and 2007, we have expensed $1.3million and $0.7 million, respectively, to stock compensation expense. Theforfeitures, noted above, resulted from shares used to satisfy employees’ taxwithholding obligations related to the vesting of restricted shares, and theretirement of a key employee, which resulted in the forfeiture of non-vestedrestricted shares.

 

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

 

For the six months ended December 31, 2008, wegranted 449,400 stock options to non-executive employees and 125,000 stockoptions to our directors under our 2005 Long-Term Incentive Plan.  The options were granted with an exerciseprice equal to our market price at the date of grant and expire after tenyears.  These stock option awards vestanywhere from immediate vesting (for directors) to three years, based uponcontinuous service.  The factors used tocalculate the fair value of these options are summarized in the table below.

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

 

The fair value of each stock option is estimated onthe date of grant using the Black-Scholes option-pricing model. Expectedvolatility is based on the historical volatility of our common stock. We usehistorical data to 

 

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estimateoption exercise and employee termination within the valuation model. Theexpected lives of options granted represent the period of time that optionsgranted are expected to be outstanding. The risk-free interest rate for periodswithin the contractual life of the option is based on the five-year U.S.Treasury yield curve in effect at the time of the respective grant. Theexpected dividend yield reflects our intent not to pay dividends on our commonstock during the contractual periods.

 

A summary of outstanding options as of December 31,2008 is as follows:

 
| ** **                            | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------|------------|------------|------------|------------------------------------------------|------------|
| Outstanding at June 30, 2008     |       | 1,084,051  |       | $                                              | 5.71       |   |
| Options granted                       |       | 574,400    |       | $                                              | 1.86       |   |
| Options forfeited                     |       | (90,133    | )          | $                                              | 5.59       |   |
| Outstanding at December 31, 2008 |       | 1,568,318  |       | $                                              | 4.31       |   |

 

Based on our $0.44 stock price at December 31,2008, the intrinsic value of the options outstanding and exercisable wasapproximately $3,000 and $1,000, respectively.

 

Total options exercisable at December 31, 2008amounted to 661,803 shares and had a weighted average exercise price of$4.72.  Upon exercise, we issue the full amount of shares exercisable perthe term of the options from new shares.

 

For the quarters ended December 31, 2008 and2007, we recorded charges to stock compensation expense of $0.3 million and$0.7 million for the estimated fair value of the options granted to ourdirectors and employees.  For each of thesix months ended December 31, 2008 and 2007, we recorded charges to stockcompensation expense of $0.5 million and $1.0 million for the estimated fairvalue of the options granted to our directors and employees.

 

**9.****    ****NET INCOME (LOSS) PER COMMONSHARE**

 

Basic net income (loss) per common share is computedby dividing the net income (loss) attributable to common stockholders by theweighted average number of shares of common stock outstanding less unvestedrestricted shares during the period. Diluted net income (loss) per common share is computed in the samemanner, but also considers the effect of common stock shares underlying stockoptions, the Series D Convertible Preferred Stock, PIK dividends andunvested restricted stock.

 

The following table reconciles earnings and sharesused in the computation of basic and diluted earnings per share for the threeand six months ended December 31, 2008:

 
| ** **                                                       | ** ** | **Three Months** | ** ** | **Six Months** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|---------------------|------------|
| ** **                                                       | ** ** | ** **            | ** ** | ** **          | ** ** | **Earnings** | ** ** | ** ** | ** ** | ** ** | ** ** | **Earnings** | ** ** |
| **In thousands, except per share data** | ** ** | **Earnings**          | ** ** | **Shares**          | ** ** | **per Share** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **per Share** | ** ** |
| Basic                                                            |       | $                     | 13,653     |                | 45,422     |   | $ | 0.30 |   | $ | 25,471 |   | 45,380 |   | $ | 0.56 |   |
|                                                             |       |                  |       |                |       |   |   |   |   |   |   |   |   |
| Effective of dilutive securities:                                |       |                  |       |                |       |   |   |   |   |   |   |   |   |
| Conversion of preferred stock and PIK  dividends                 |       | 855                   |       | 7,758               |       |   |   | 1,791 |   | 8,107 |   |   |   |
| Stock options                                                    |       | —                |       | 95                  |       |   |   | — |   | 256 |   |   |   |
| Diluted                                                          |       | $                     | 14,508     |                | 53,275     |   | $ | 0.27 |   | $ | 27,262 |   | 53,743 |   | $ | 0.51 |   |

 

Weighted average non-vested restricted shares forthe three and six months ended December 31, 2008 of 656,667 and 853,334 shares,respectively, are not included in the weighted average shares outstanding forthe three and six months ended December 31 2008 as their effects wouldhave been anti-dilutive.

 

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As of December 31, 2007, shares of common stockunderlying the following items summarized below were not included in theweighted average shares outstanding for the three and six months ended December 31,2007 as their effects would have been anti-dilutive.

 
| Stock options                |   | 996,754   |   |
|------------------------------|--------|-----------|--------|
| Warrants                     |   | 1,646,061 |   |
| Preferred stock              |   | 7,846,261 |   |
| PIK dividends                |   | 489,191   |   |
| Non-vested restricted shares |   | 465,000   |   |

 

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

 

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

 

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

 

Statement of Financial Accounting Standards No. 157,*Fair Value Measurements*, (“SFAS No. 157”)was issued by the FASB in September 2006. SFAS No. 157 defines fairvalue, establishes a framework for measuring fair value under GAAP and expandsdisclosures about fair value measurements. SFAS No. 157 applies to otheraccounting pronouncements that require or permit fair value measurement. Weadopted SFAS No. 157 on July 1, 2008. The initial adoption of SFAS 157 had no material impact to our financialposition, results of operations or cash flows.

 

Fair value is the price that would be received tosell an asset or the amount paid to transfer a liability in an orderlytransaction between market participants (an exit price) at the measurementdate. Fair value is a market based measurement considered from the perspectiveof a market participant. We use market data or assumptions that market participantswould use in pricing the asset or liability, including assumptions about riskand the risks inherent in the inputs to the valuation. These inputs can bereadily observable, market corroborated, or unobservable. If observable pricesor inputs are not available, unobservable prices or inputs are used to estimatethe current fair value, often using an internal valuation model. Thesevaluation techniques involve some level of management estimation and judgment,the degree of which is dependent on the item being valued.  We primarily apply a market approach forrecurring fair value measurements using the best available information whileutilizing valuation techniques that maximize the use of observable inputs andminimize the use of unobservable inputs. Our valuation includes the effect of potential non-performance by thecounterparties.

 

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

 

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

 

Level2—Inputs are other than quoted prices in active markets included in Level 1,which are either directly or indirectly observable. These inputs are eitherdirectly observable in the marketplace or indirectly 

 

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observablethrough corroboration with market data for substantially the full contractualterm of the asset or liability being measured.

 

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

 

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

 

The fair value of our derivative contracts aremeasured using Level 2 inputs based on the hierarchies previously discussed.

 

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

 

The estimated fair values of derivatives included inthe consolidated balance sheet at December 31, 2008 are summarized below.

 
| **In thousands**                              | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|
| Derivative assets (Level 2):                       |       |       |       |
| Crude oil collars and price floors -  current      |       | $          | 6,189      |   |
| Crude oil collars and price floors -  noncurrent   |       | 4,983      |       |
| Natural gas collars and price floors -  current    |       | 1,778      |       |
| Natural gas collars and price floors -  noncurrent |       | 1,181      |       |
| Total derivative assets (Level 2)                  |       | $          | 14,131     |   |
| Asset retirement obligation (Level 3)              |       | $          | (3,336     | ) |

 

At September 30, 2008, our net derivativeliability was classified as Level 3 due to the subjectivity of our valuationfor the effect of our own credit risk. Since we have derivative assets at December 31, 2008, we no longerhave a subjective valuation of our own credit risk.  Therefore, we have reclassified ourderivative assets as Level 2 at December 31, 2008.

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

 

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

 

The following table shows the reconciliation ofchanges in the fair value of the net derivative liability and asset retirementobligation classified as Level 2 and 3, respectively, in the fair valuehierarchy for the quarter ended December 31, 2008.

 

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| ** **                                | ** ** | **Total**      | ** ** | **Asset**      | ** ** |
|-------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                | ** ** | **Derivative** | ** ** | **Retirement** | ** ** |
| **In thousands**                     | ** ** | **Assets**     | ** ** | **Obligation** | ** ** |
| Balance at June 30, 2008                  |       | $              | (26,243    | )              | $          | 3,403 |   |
| Unrealized gain                           |       | 43,180         |       | —         |       |
| Sale of “price floor” contracts |       | (1,169         | )          | —         |       |
| Settlements, net                          |       | (1,637         | )          |           |       |
| Accretion of discount                     |       | —         |       | 150            |       |
| Sale of Pantwist, LLC (Note 2)            |       | —         |       | (90            | )          |
| Sale of Corsicana Properties (Note 2)     |       |           |       | (102           | )          |
| Liabilities settled                       |       | —         |       | (25            | )          |
| Balance at December 31, 2008              |       | $              | 14,131     |           | $          | 3,336 |   |

 

The change from net derivative liabilities of $26.2million at June 30, 2008 to net derivative assets of $14.1 million at December 31,2008 is primarily attributable to the effect of lower crude oil and natural gasprices.

 

**12.**** ****IMPAIRMENT OF LONG-LIVEDASSETS AND GOODWILL**

 

In light of current commodity prices, we believethere is uncertainty in the likelihood of our developing proved undevelopedreserves associated with our Barnett Shale natural gas properties (“BarnettShale Properties”) within the next five years. Accordingly, during the quarter ended December 31, 2008, werecorded a $22.4 million pre-tax impairment to our Barnett Shale Properties anda $0.7 million pre-tax impairment to Goodwill associated with our subsidiarywhich holds the equity in our Barnett Shale Properties.

 

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

 

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

 

**13.**** ****COMMITMENTS ANDCONTINGENCIES**

 

***Burnett Case***

 

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

 

The plaintiffs (i) allege negligence and grossnegligence and (ii) seek damages, including, but not limited to, damagesfor damage to their land and livestock, certain expenses related to fightingthe fire and certain remedial expenses totaling approximately $1.7 millionto $1.8 million. In addition, the plaintiffs seek (i) termination ofcertain oil and natural gas leases, (ii) reimbursement for their attorney’sfees (in the amount of at least $549,000) and (iii) exemplary damages. Theplaintiffs also claim that Cano and its subsidiaries are jointly and severallyliable as a single business enterprise and/or a general partnership or de factopartnership. The owner of the remainder of the mineral estate, Texas ChristianUniversity, intervened in the suit on August 18, 2006, joining Plaintiffs’request to terminate certain oil and gas leases.

 

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On June 21, 2007, the Judge of the 100th Judicial District Court issued a Final Judgment (a) grantingmotions for summary judgment in favor of Cano and certain of its subsidiarieson plaintiffs’ claims for (i) breach of contract/termination of an oil andgas lease; and (ii) negligence; and (b) granting the plaintiffs’no-evidence motion for summary judgment on contributory negligence, assumptionof risk, repudiation and estoppel affirmative defenses asserted by Cano andcertain of its subsidiaries. The Final Judgment has been appealed.

 

***Settled Cases***

 

On April 28, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of RobertsCounty, Texas: Cause No. 1922, Robert and Glenda Adcock, et al. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. (“Adcock”).The plaintiffs claimed that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) alleged negligence, res ipsa loquitor, trespass andnuisance and (ii) sought damages, including, but not limited to, damagesto their land, buildings and livestock and certain remedial expenses totaling$5,439,958. In addition, the plaintiffs sought (i) reimbursement for theirattorney’s fees and (ii) exemplary damages. The plaintiffs also claimedthat Cano and its subsidiaries were jointly and severally liable as a singlebusiness enterprise and/or a general partnership or de facto partnership. Theclaims of all plaintiffs in this suit were resolved through a Settlement andRelease Agreement effective November 5, 2008 and were dismissed withprejudice.

 

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

 

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

 

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

 

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

 

On May 1, 2006, the following lawsuit was filedin the 31st Judicial District Court of Roberts County, Texas: Cause No. 1923,Chisum Family Partnership, Ltd. v. Cano, W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. (“Chisum”).The plaintiff claimed that the electrical 

 

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wiringand equipment of Cano or certain of its subsidiaries relating to oil and gasoperations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas. The plaintiff (i) alleged negligence and trespass and (ii) soughtdamages of $53,738.82, including, but not limited to, damages to their land andcertain remedial expenses. In addition, the plaintiffs sought exemplarydamages. The claims of all plaintiffs and intervenor were resolved through aSettlement and Release Agreement effective December 9, 2008 and were dismissedwith prejudice.

 

On August 9, 2006, the following lawsuit wasfiled in the 233rd Judicial District Court of Gray County, Texas, Cause No. 34,423,Yolanda Villarreal, Individually and on behalf of the Estate of GerardoVillarreal v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd., and WO Energy, Inc. (“Villarreal”).The plaintiffs claimed that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started a wildfirethat began on March 12, 2006 in Carson County, Texas. The plaintiffs (i) allegednegligence and (ii) sought damages for past and future financial supportin the amount of $586,334, in addition to undisclosed damages for wrongfuldeath and survival damages, as well as exemplary damages, for the wrongfuldeath of Gerardo Villarreal who they claimed died as a result of the fire. Theplaintiffs also claimed that Cano and its subsidiaries were jointly andseverally liable under vicarious liability theories. On August 22, 2006,relatives of Roberto Chavira intervened in the case alleging similar claims andsought damages for lost economic support and lost household services in theamount of $894,078, in addition to undisclosed damages for wrongful death andsurvival damages, as well as exemplary damages regarding the death of RobertoChavira. The claims of all plaintiffs and intervenors were resolved throughSettlement and Release Agreements effective December 8, 2008 and weredismissed with prejudice.

 

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

 

On May 2, 2007, the following lawsuit was filedin the 84th Judicial District Court of HutchinsonCounty, Texas, Cause No. 37,619, Gary and Genia Burgess,et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Burgess”).Eleven plaintiffs claimed that electrical wiring and equipment relating to oiland gas operations of the Company or certain of its subsidiaries started awildfire that began on March 12, 2006 in Carson County, Texas. Five of theplaintiffs were former plaintiffs in the Adcock matter. The plaintiffs (i) allegednegligence, res ipsa loquitor, nuisance, and trespass and (ii) soughtdamages, including, but not limited to, damages to their land, buildings andlivestock and certain remedial expenses totaling approximately $1,997,217.86.In addition, the plaintiffs sought (i) reimbursement for their attorney’sfees and (ii) exemplary damages. The plaintiffs also claimed that Cano andits subsidiaries were jointly and severally liable as a single businessenterprise and/or as a partnership or de facto partnership. The claims of allplaintiffs were resolved through a Settlement and Release Agreement effective November 5,2008 and were dismissed with prejudice.

 

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

 

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

 

On October 3, 2007, Firstbank Southwest, asTrustee for the John and Eddalee Haggard Trust (the “Trust”) filed a Petitionin intervention as part of the Hutchison case. The Trust claimed that theelectrical wiring and equipment of Cano or certain of its subsidiaries relatingto oil and gas operations started a wildfire that began on March 12, 2006in Carson County, Texas. The Trust (i) alleged negligence and trespass and(ii) sought damages of $46,362.50, including, but not limited to, damagesto land and certain remedial expenses. In addition, the Trust sought exemplarydamages. The claims of this intervenor were resolved through a Settlement andRelease Agreement effective December 9, 2008 and were dismissed withprejudice.

 

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

 

On January 15, 2008, the Jones and McMordieRanch Partnership intervened in the consolidated case in the200th District Court of Travis County, Texas as part of the SPS case. Theintervenor (i) alleged negligence, trespass and nuisance and (ii) soughtdamages of $86,250.71, including, but not limited to, damages to his livestock,attorney’s fees and exemplary damages. The intervenor also claimed that Canoand its subsidiaries were jointly and severally liable as a single businessenterprise and/or as a partnership or de facto partnership. The claims of thisintervenor were resolved through a Settlement and Release Agreement effective December 9,2008 and were dismissed with prejudice.

 

On February 11, 2008, the following lawsuit wasfiled in the 48th Judicial District Court of TarrantCounty, Texas: Cause No. 048-228763-08, Abraham Equine, Inc. v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Abraham Equine”). Theplaintiff claimed that the electrical wiring and equipment of Cano or certainof its subsidiaries relating to oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County. The plaintiff (i) allegednegligence, trespass and nuisance and (ii) sought damages of $1,608,000,including, but not limited to, damages to its land, livestock and lost profits.In addition, the plaintiff sought (i) reimbursement for its attorney’sfees and (ii) exemplary damages. The plaintiff also claimed that Cano andits subsidiaries were jointly and severally liable as a single businessenterprise and/or a general partnership or de facto partnership. Cano and itssubsidiaries filed a Motion to Dismiss or, in the Alternative, to TransferVenue and a Notice of Tag Along transferring the case to the MultidistrictLitigation Case in the 200th Judicial District Court of TravisCounty, Texas. On May 2, 2008, the Court heard Cano’s Motion to Dismissor, in the Alternative, to Transfer Venue and took the motion underadvisement.  This suit (along with the claims of AbrahamBrothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abraham and JasonM. Abraham, discussed above) was resolved through a Settlement and ReleaseAgreement effective October 12, 2008 and were dismissed with prejudice.

 

On March 10, 2008, the following lawsuit wasfiled in the 352nd Judicial District Court of TarrantCounty, Texas, Cause No. 352-229256-08, Gary Pfeffer v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc.(“Pfeffer”). The plaintiff claimed that the electrical wiring and equipment ofCano or certain of its subsidiaries relating to oil and gas operations starteda wildfire that began on March 12, 2006 in Carson County. The plaintiff (i) allegednegligence, trespass and nuisance, (ii) sought undisclosed damages for thewrongful death of his father, Bill W. Pfeffer, who he claimed died as aresult of the fire and 

 

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(iii) soughtactual damages of $1,023,572.37 for damages to his parents’ home and property.In addition, the plaintiff sought exemplary damages. The plaintiff also claimedthat Cano and its subsidiaries were jointly and severally liable as a generalpartnership or de facto partnership. Cano and its subsidiaries filed a Motionto Dismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Alongtransferring the case to the Multidistrict Litigation Case in the 200th Judicial District Court of Travis County, Texas. On May 2,2008, the Court heard Cano’s Motion to Dismiss or, in the Alternative, toTransfer Venue and took the motion under advisement. The claims of plaintiffwere resolved through a Settlement and Release Agreement effective December 10,2008 and were dismissed with prejudice.

 

On March 11, 2008, the following lawsuit wasfiled in the 141st Judicial District Court of TarrantCounty, Texas, Cause No. 141-229281-08, Pamela Ayers, et al. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W.O.Operating, Ltd. and WO Energy, Inc. (“Ayers”). The plaintiffs claimedthat the electrical wiring and equipment of Cano or certain of its subsidiariesrelating to oil and gas operations started a wildfire that began on March 12,2006 in Carson County. The plaintiffs (i) alleged negligence and (ii) soughtundisclosed damages for the wrongful death of their mother, Kathy Ryan, whothey claimed died as a result of the fire. In addition, the plaintiffs soughtexemplary damages. The plaintiffs also claimed that Cano and its subsidiarieswere jointly and severally liable as a single business enterprise and/orgeneral partnership or de facto partnership. Cano and its subsidiaries filed aMotion to Dismiss or, in the Alternative, to Transfer Venue and a Notice of TagAlong transferring the case to the Multidistrict Litigation Case in the 200th Judicial District Court of Travis County, Texas. On May 2,2008, the Court heard Cano’s Motion to Dismiss or, in the Alternative, toTransfer Venue and took the motion under advisement. The claims of plaintiffswere resolved through a Settlement and Release Agreement effective December 10,2008 and were dismissed with prejudice.

 

On March 12, 2008, the following lawsuit wasfiled in the 17th Judicial District Court of TarrantCounty, Texas, Cause No. 017-229316-08, The Travelers Lloyds InsuranceCompany and Travelers Lloyds of Texas Insurance Company v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc.(“Travelers”). The plaintiffs claimed that the electrical wiring and equipmentof Cano or certain of its subsidiaries relating to oil and gas operationsstarted a wildfire that began on March 12, 2006 in Carson County. Theplaintiffs (i) alleged negligence, res ipsa loquitor, and trespass and (ii) claimedthey are subrogated to the rights of their insureds for damages to theirbuildings and building contents totaling $447,764.60. The plaintiffs alsoclaimed that Cano and its subsidiaries were jointly and severally liable as asingle business enterprise and/or general partnership or de facto partnership.The claims of plaintiffs were resolved through a Settlement and ReleaseAgreement effective November 18, 2008 and were dismissed with prejudice.

 

***RemainingCase***

 

On December 18, 2007, the following lawsuit wasfiled in the 348th Judicial District Court of TarrantCounty, Texas, Cause No. 348-227907-07, Norma Valenzuela,et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Valenzuela”). Sixplaintiffs, including the two plaintiffs and intervenor from the nonsuitedMartinez case, claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) allege negligence and (ii) seek actual damages in theminimal amount of $4,413,707 for the wrongful death of four relatives, ManuelDominguez, Roberto Chavira, Gerardo Villarreal and Medardo Garcia, who theyclaim died as a result of the fire. In addition, plaintiffs seek (i) reimbursementfor their attorney’s fees and (ii) exemplary damages. The plaintiffs alsoclaim that Cano and its subsidiaries are jointly and severally liable as asingle business enterprise and/or as a partnership or de facto partnership.Cano and its subsidiaries filed a Motion to Dismiss or, in the Alternative, toTransfer Venue and a Notice of Tag Along transferring the case to theMultidistrict Litigation Case in the 200th JudicialDistrict Court of Travis County, Texas. On May 2, 2008, the Court heardCano’s Motion to Dismiss or, in the Alternative, to Transfer Venue and took themotion under advisement.

 

Due to the inherent riskof litigation, the ultimate outcome of this case and any jury trial isuncertain and unpredictable.  At thistime, Cano management continues to believe that this lawsuit and the Burnettare without merit and will continue to vigorously defend itself and itssubsidiaries, while seeking solutions to resolve these lawsuits in acost-effective manner.

 

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***Insurance Settlements Related to the FireLitigation***

 

On June 20, 2006,the following lawsuit was filed in the United States District Court for theNorthern District of Texas, Fort Worth Division, C.A. No. 4-06cv-434-A,Mid-Continent Casualty Company (“Mid Con”), Plaintiff, vs. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W.O. Operating Company, Ltd.and W.O. Energy, Inc. seeking a declaration that the plaintiff is notresponsible for pre-tender defense costs and that the plaintiff has the soleand exclusive right to select defense counsel and to defend, investigate,negotiate and settle the litigation described above. On September 18,2006, the First Amended Complaint for Declaratory Judgment was filed withregard to the cases described above. Cano and its subsidiaries were served withthe lawsuit between September 26-28, 2006.

 

On February 9,2007, Cano and its subsidiaries entered into a Settlement Agreement and Releasewith the plaintiff pursuant to which in exchange for mutual releases, inaddition to the approximately $923,000 that we have been reimbursed byplaintiff, the plaintiff agreed to pay to Cano within 20 business days of February 9,2007 the amount of $6,699,827 comprising the following: (a) the $1,000,000policy limits of the primary policy; (b) the $5,000,000 policy limits ofthe excess policy; (c) $500,000 for future defense costs; (d) $144,000as partial payment for certain unpaid invoices for litigation related expenses;(e) all approved reasonable and necessary litigation related expensesthrough December 21, 2006 that are not part of the above-referenced$144,000; and (f) certain specified attorneys fees. During February 2007,we received the $6,699,827 payment from Mid-Con. Of this $6,699,827 amount, thepayments for policy limits amounting to $6,000,000 were recorded as a liabilityunder deferred litigation credit as presented on our consolidated balancesheet.

 

On March 11, 2008,one of Cano’s subsidiaries entered into a tolling agreement with an independentelectrical contractor that was identified as a potentially responsible thirdparty in connection with the claims related to the pending wildfire litigationagainst Cano and its subsidiaries.  Inaccordance with the terms of a Settlement and Release Agreement effective October 11,2008, the independent electrical contractor paid Cano its full insurance policylimits totaling $6.0 million in exchange for a full release of any existing orfuture claims related to wildfires that began on March 12, 2006 in CarsonCounty, Texas.  The $6.0 million wasreceived on October 31, 2008.

 

The $12.0 million ofinsurance proceeds (from Mid-Con and the independent electrical contractor)have been expended directly or indirectly to pay the settlements describedabove. Accordingly, as of December 31, 2008, we no longer have a deferredlitigation credit balance.  Based on ourknowledge and judgment of the facts as of December 31, 2008, we believeour financial statements present fairly the effect of actual and anticipatedultimate costs to resolve these matters as of December 31, 2008.

 

***Securities Litigation against OutsideDirectors***

 

On October 2, 2008, a lawsuit (08 CV 8462) wasfiled in the United States District Court for the Southern District of NewYork, against David W. Wehlmann; Gerald W. Haddock; Randall Boyd; Donald W.Niemiec; Robert L. Gaudin; William O. Powell, III and the underwritersalleging violations of the federal securities laws.  The plaintiff seeks to certify the lawsuit asa class action.  The lawsuit alleges thatthe prospectus for the June 26, 2008 public offering of Cano common stockcontained statements regarding Cano’s proved reserve amounts and standards thatwere materially false and overstated Cano’s proved reserves.  Messrs. Wehlmann, Haddock, Boyd,Niemiec, Gaudin and Powell were Cano outside directors on June 26,2008.  The lawsuit seeks an unspecifiedamount of damages for the class if the lawsuit is certified as a class action.  Dueto the inherent risk of litigation, the outcome of this lawsuit is uncertainand unpredictable; however, at this time, our outside directors named in thelawsuit and management believe the lawsuit is without merit.  Management is cooperating with the Company’sDirectors and Officers insurance provider in the defense of the claims againstthese outside directors.

 

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***Other***

 

Occasionally, we areinvolved in other various lawsuits and certain governmental proceedings arisingin the ordinary course of business. Our management does not believe that theultimate resolution of any current matters that are not set forth above, willhave a material effect on our financial position or results of operations.Management’s position is supported, in part, by the existence of insurancecoverage, indemnification and escrow accounts. None of our directors, officersor affiliates, owners of record or beneficial owners of more than five percentof any class of our voting securities, or security holder is involved in aproceeding adverse to us or our subsidiaries or has a material interest adverseto us or our subsidiaries.

 

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

 

**Forward-Looking Statements**

 

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

 

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

 

**Operating Strategy**

 

Weare an independent oil and natural gas company that utilizes enhanced oilrecovery (“EOR”) techniques to increase the production and reserves of ourexisting portfolio of properties. We anticipate that we would utilize EORtechniques to increase production and reserves at any properties we may acquirein the future.  Our assets are located onshore U.S. in Texas, New Mexicoand Oklahoma. Our focus on domestic, mature oil fields eliminates exploration riskand the uncertainty associated with international development.  Weprimarily use waterflooding and EOR techniques, such as alkaline/ surfactant/polymer (“ASP”), to develop our properties.

 

Ourtotal reserves have changed from June 30, 2008 due to the sales ofPantwist, LLC (Note 2) and our Corsicana Properties (Note 2), as summarized inthe following table.

 
| **Reserves Category   (MMBOE)** | ** ** | **Reported in   10-K dated   June 30, 2008** | ** ** | **Less: Sale of   Properties** | ** ** | **Estimated Reserves   at December 31,   2008(a)** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| PDP                                       |       | 10.6                                                                       |       | (1.9                                          | )          | 8.7                                                                         |       |
| PDNP                                      |       | 2.5                                                                        |       | —                                        |       | 2.5                                                                         |       |
| PUD                                       |       | 40.1                                                                       |       | (0.7                                          | )          | 39.4                                                                        |       |
| **Total Proved**                          | ** ** | **53.2**                                                                   | ** ** | **(2.6**                                      | **)**      | **50.6**                                                                    | ** ** |

 

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

 

Thefall in crude oil and natural gas prices from June 30, 2008 to December 31,2008 caused us to reclassify all our proved undeveloped reserves at ourDesdemona Properties, or 2.3 MMBOE (Note 12) out of proved reserves.  While our next reserve report disclosure willbe at June 30, 2009, assuming December 31, 2008 prices the economiclives of some of our properties would be shortened, causing a decrease ofapproximately 2.0-3.0 MMBOE of proved reserves.

 

Webelieve our oil and natural gas properties provide ample opportunities to applyour operational strategy.  Crude oilreserves accounted for 74% of our total proved reserves at December 31,2008. Our primary focus is to develop our existing oil and natural gas propertiesthrough activities such as waterflooding and EOR technology. These developmentactivities are more clearly outlined in the next section titled “DrillingCapital Development and Operating Activities Update.”

 

***Drilling Capital Development and Operating ActivitiesUpdate***

 

OnFebruary 2, 2009, our board of directors approved an increase in ourdrilling capital development budget for our fiscal year ending June 30,2009 (“2009 Fiscal Year”) to $38.5 million from the budgeted amount of $35.5million.  The increase is due to earlierthan expected waterflood response at the Cato Properties and the opportunity toincrease water injection at our Panhandle Properties.  The approved $38.5 million is allocated toour properties as follows:

 

·                  $20.5 millionat the Cato Properties;

 

·                  $13.0 millionat the Panhandle Properties;

 

·                  $1.7 millionat the Nowata Properties;

 

·                  $2.7 millionat the Desdemona Properties; and

 

·                  $0.6 millionat other projects.

 

Ofthe $38.5 million budgeted capital expenditures, we have incurred $33.2 millionthrough December 31, 2008.  Thefinancing of our capital expenditures is discussed below under “Liquidity andCapital Resources.” The status of our capital development activity during the2009 Fiscal Year, including the drilling of 18 new wells, is summarized asfollows:

 

***Panhandle Properties.***     Initial baseproduction at the Cockrell Ranch Unit waterflood has remained at approximately80-100 net BOEPD between June and December 2008.  During the first quarter, as a result of ourpreviously announced surveillance program, we identified and correctedinjection issues in 16 of the 62 injector wells.  With the results of the surveillance and thecorrective action taken, we now estimate the effective pore volume injection (“PVI”)at Cockrell Ranch to be approximately .20 PVI. The surveillance programincluded drilling one observation well which has since been completed as aproducer during January 2009.

 

TheCockrell waterflood has been at full injection for 10 months with correctedinjection since October 2008.  Weare still early in the life of this waterflood, and the surveillance measureswe have taken are normal. Of note, there are areas of the flood that areresponding favorably, with oil saturations between 4% - 10%. Based upon currentobservations, we expect to see a more direct correlation of PVI versus oilsaturations and corresponding oil production.

 

Ouroriginal Panhandle waterflood capital development plan included six separatemini-floods on reduced well spacing to enable us to accelerate fielddevelopment. Tighter spacing and smaller development patterns should 

 

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quickenpermitting and response times, allowing a larger development footprint over agreater acreage position of the field. The current capital development planprovides for the development of only one mini-flood phase this fiscal year. TheHarvey Unit had its waterflood permit application approved by the TexasRailroad Commission on October 20, 2008. The Harvey unit mini-floodconsists of six injection wells and 13 producing wells (which required five newwells to be drilled among the existing wells at the field). The drilling of thefive development wells was completed on January 5, 2009, thus completingthe mini-flood pattern. We anticipate initiating injection by the end of March 2009.We expect to file the appropriate waterflood permits for the remaining fivemini-floods by April 2009.  Netproduction at the Panhandle Properties for December 2008 was approximately600 BOEPD.

 

***Cato Properties.***     In July 2008,we reinstated our drilling program after a three month pause.  In the first quarter of the 2009 Fiscal Yearwe drilled and completed six waterflood infill wells, one injection well andone water source well.  We have completedour Cato drilling capital development plan for the 2009 Fiscal Year. Wecurrently have 14 water injection wells on-line and are injecting at a rate ofapproximately 7,000 barrels of water per day. In total, this initial phase ofthe Cato waterflood encompasses roughly 640 acres, and includes 14 injectionwells and 25 producing wells.  Netproduction for December 2008 at the Cato Properties was approximately 250BOEPD.

 

***Desdemona Properties.***    In light of currentcommodity prices and our revised drilling capital budget, we believe there isuncertainty in the likelihood of our developing proved undeveloped reservesassociated with our Barnett Shale natural gas properties (“Barnett ShaleProperties”) within the next five years. Accordingly, during the quarter ended December 31, 2008, werecorded a $22.4 million pre-tax impairment to our Barnett Shale Properties(Note 12).

 

InJanuary 2009, we shut in four uneconomic horizontal Barnett Shale wellsand four uneconomic vertical Barnett Shale/Marble Falls producers.  We expect this action to reduce netproduction from the Desdemona Properties by 10-14 BOEPD.  We have taken actions to reduce our leaseoperating expenses at Desdemona by approximately 50% while we continue towaterflood the Duke Sands. Even though we do not anticipate seeing a meaningfulresponse from the Duke Sands waterflood during the 2009 Fiscal Year, we believethis is an attractive project for converting probable reserves to provedreserves. We will continue to manage this property as a marginally profitablefield until such time as commodity prices return to levels that provide anappropriate return and thus justify new development capital spending.  Net production for December 2008 at theDesdemona Properties was approximately 70 BOEPD.

 

***Nowata Properties.***    Our ASP tertiaryrecovery pilot project, which has been in full operation since December 2007,has injected close to .18 PVI of ASP. We have now completed the ASP stageof injection and we are performing the final injection stage of polymer flush.We drilled and completed four observation wells. The observation wells shouldallow us to test flood-front results in our ASP pilot. Net production for December 2008at the Nowata Properties was approximately 220 BOEPD.

 

***Davenport Properties.***    Net production for December 2008was approximately 65 BOEPD.

 

**Liquidity and Capital Resources**

 

Forthe six months ended December 31, 2008, our primary sources of cash werereceipts from the sale of crude oil and natural gas production, issuance of commonstock, net borrowings under our credit agreements, sales of oil and gasproperties, payments for in-the-money commodity derivative contracts and asettlement from a third party pertaining to the Panhandle fire litigation. Ourcash receipts from sales are discussed in greater detail under *“Results of Operations – Operating Revenues.” *The other sources of cash arediscussed in greater detail below:

 

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

 

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·      On October 1, 2008, we sold ourwholly-owned subsidiary, Pantwist, LLC (“Pantwist”), for $42.7 million ($40.0million net of certain closing adjustments, $2.2 million of discontinuedoperations income recorded in the first quarter of the 2009 Fiscal Year and$0.6 million of advisory fees - Note 2).

 

·      On December 2, 2008, we sold ourinterests in the Corsicana Properties for $0.3 million (Notes 2 and 12).

 

·      During October 2008, we sold certainuncovered “floor price” commodity derivative contracts covering July 2010to December 2010 for $0.6 million to our counterparty, and during November 2008,we sold all remaining uncovered “floor price” commodity derivative contractscovering November 2008 through June 2010 for $2.6 million to ourcounterparty.  We recorded a realizedgain of $0.7 million and an unrealized gain of $1.3 million as a result ofthese two transactions.

 

·      On October 31, 2008, an independentelectrical contractor paid us $6.0 million (its full insurance policy limits)in exchange for a full release of any existing or future claims related towildfires that began on March 12, 2006 in Carson County, Texas.  The $6.0 million has been fully expended tocover the settlements discussed in Note 13.

 

Duringthe six month period ended December 31, 2008, our cash outlays wereprimarily for:

 

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

 

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

 

·      As discussed in Note 6, during November andDecember 2008, we repurchased 22,948 shares of Series D ConvertiblePreferred Stock, including accrued and unpaid PIK dividends relating to suchshares for approximately $10.5 million.

 

Asdiscussed in Note 4, at December 31, 2008, our remaining availableborrowing capacity under the senior and subordinated credit agreements are$30.0 million and $15.0 million, respectively. We intend to draw down from our available borrowing capacity to fund ouroperations, capital development program as previously discussed under “*Drilling**CapitalDevelopment and Operating Activities Update*,” for general corporatepurposes and for selective acquisitions.

 

AtDecember 31, 2008, our cash balance was $0.7 million.  For the six months ended December 31,2008 and 2007, our cash from operations is summarized in the following table:

 
| **In Thousands**                      | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Cash provided by (used in) operations      |       | $        | (3,141     | )        | $          | 7,507 |   |
| Exclude unusual items:                     |       |     |       |     |       |
| Fire litigation settlements, net           |       | 7,440    |       | —   |       |
| Release of restrictions on Restricted Cash |       | —   |       | (3,182   | )          |
| Normalized cash provided by operations     |       | $        | 4,299      |     | $          | 4,325 |   |

 

Normalizedcash provided by operations is a NON-GAAP measure; however, we believe that thepresentation of “normalized cash provided by operations” is relevant and usefulto users of our financial statements. We believe the net payments for firelitigation settlements and cash from restricted cash are unusual to our normalbusiness activities, and should be excluded for comparison purposes between thetwo six-month periods.  The exclusion ofthese two items shows our cash from operations is comparable between the twosix-month periods.  We believe this ishelpful information to our users of our financial statements to understand ourcurrent and future cash flow from operations.

 

Webelieve the combination of cash on hand, cash flow generated from the expectedsuccess of prior capital development projects and debt available under ourcredit agreements is sufficient to finance our operations, 

 

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contractualobligations and capital expenditure program (as previously discussed in thesection titled “*Drilling**Capital Development and Operating Activities Update”)*.

 

OnDecember 28, 2007, our universal shelf registration statement was declaredeffective by the SEC for the issuance of common stock, preferred stock,warrants, senior debt and subordinated debt up to an aggregate amount of $150.0million.  After the issuance of common stock on July 1, 2008, we have$96.0 million of availability under this registration. We may periodicallyoffer one or more of these securities in amounts, prices and on terms to beannounced when and if the securities are offered. At the time any of the securitiescovered by the registration statement are offered for sale, a prospectussupplement will be prepared and filed with the SEC containing specificinformation about the terms of any such offering.  We have no immediateplans to utilize the availability under the universal shelf registrationstatement.

 

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

 

**Results of Operations**

 

Forthe quarter ended December 31, 2008 (“current quarter”), we had incomeapplicable to common stock of $2.8 million, which was $4.4 million higher ascompared to the $1.6 million loss applicable to common stock incurred for thequarter ended December 31, 2007 (“prior year quarter”).  Items thatpositively impacted the $4.6 million increase were increased unrealized gainson commodity derivatives of $20.8 million, higher realized gains on commodityderivatives of $2.4 million and higher income of $11.5 million fromdiscontinued operations.  These positiveitems were partially offset by higher operating expenses of $30.7 million(including a $22.4 million impairment charge at our Desdemona Property), loweroperating revenues of $2.8 million and a goodwill impairment of $0.7 million.

 

Forthe six months ended December 31, 2008 (“current six months”), we hadincome applicable to common stock of $14.6 million, which was $17.4 millionhigher as compared to the $2.8 million loss applicable to common stock incurredfor the six months ended December 31, 2007 (“prior year six months”).   Items that positively impacted the $17.6million increase were increased revenues of $1.5 million, unrealized gains oncommodity derivatives of $45.5 million, higher realized gains on commodityderivatives of $1.6 million and higher income from discontinued operations of$10.0 million.  These positive factorswere partially offset by higher operating expenses of $35.4 million.

 

Theseitems will be expanded upon in the following discussion.

 

***Operating Revenues***

 

Thetable below summarizes our operating revenues for the quarter and six monthsended December 31, 2008 and 2007, respectively.

 
| ** **                         | ** ** | **Quarter ended  December 31,** | ** ** | **Increase** | ** ** | **Six months  ended December 31,** | ** ** | **Increase** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|--------------|------------|---------------------------------------------------|------------|--------------|------------|
| ** **                         | ** ** | **2008**                                  | ** ** | **2007**     | ** ** | **(Decrease)**                                    | ** ** | **2008**     | ** ** | **2007** | ** ** | **(Decrease)** | ** ** |
| Operating Revenues*(in thousands)* |       | $                                         | 4,876      |         | $          | 7,696                                             |       | $            | (2,819     | ) | $ | 15,808 |   | $ | 14,282 |   | $ | 1,526 |   |
| Sales                              |       |                                      |       |         |       |                                              |       |         |       |   |   |   |   |
| ·   Crude Oil (MBbls)    |       | 70                                        |       | 56           |       | 14                                                |       | 143          |       | 112 |   | 31 |   |
| ·   Natural Gas (MMcf)   |       | 195                                       |       | 253          |       | (58                                               | )          | 390          |       | 493 |   | (103 | ) |
| ·   Total (MBOE)         |       | 103                                       |       | 98           |       | 5                                                 |       | 208          |       | 194 |   | 14 |   |
| Average Price                      |       |                                      |       |         |       |                                              |       |         |       |   |   |   |   |
| ·   Crude Oil ($/ Bbl)   |       | $                                         | 52.55      |         | $          | 86.78                                             |       | $            | (34.23     | ) | $ | 82.72 |   | $ | 79.60 |   | $ | 3.12 |   |
| ·   Natural Gas ($/ Mcf) |       | $                                         | 5.70       |         | $          | 10.89                                             |       | $            | (5.19      | ) | $ | 9.87 |   | $ | 10.58 |   | $ | (0.71 | ) |

 

Thecurrent quarter operating revenues of $4.9 million are $2.8 million lower ascompared to the prior year quarter of $7.7 million. The $2.8 million reductionis primarily attributable to lower prices received for crude oil and natural gassales which lowered revenues by $2.1 million and $1.1 million, respectively,and by lower natural gas 

 

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salesvolumes which lowered revenues by $0.6 million. These decreases were partiallyoffset by increased crude oil sales volumes which increased revenues by $1.0million.

 

Thecurrent six months operating revenues of $15.8 million are $1.5 million higheras compared to the prior year six months of $14.3 million. The $1.5 millionincrease is primarily attributable to increased crude oil sales volumes whichincreased revenues by $1.8 million and higher prices received for crude oilsales which increased revenues by $1.0 million, partially offset by lowerprices received for natural gas sales which decreased revenues by $1.1 millionand lower natural gas sales volumes which lowered revenues by $0.2 million.

 

***Crude Oil Sales.***  Forthe current quarter, approximately 80% of the increased crude oil sales of 14MBbls were attributed to development activity at the Cato Properties, aspreviously discussed under the “*Drilling**Capital Development and Operating ActivitiesUpdate.*” Also, for the quarter, we had increased crude oil salesfrom each of our other four properties – Davenport, Nowata, Desdemona andPanhandle – due to development activity previously discussed under “*Drilling**CapitalDevelopment and Operating Activities Update.*”  For the six month period, approximately 96%of the increased crude oil sales of 31 MBbls occurred at the Cato Propertiesattributable to the reasons previously discussed for the current quarter.

 

***Natural Gas Sales***. For the current quarter and current sixmonths, the overall decrease in natural gas sales of 59 MMcf and 103 MMcf,respectively, pertains primarily to reductions at our Barnett Shale project atour Desdemona Properties due to the steep decline curves associated withBarnett Shale wells coupled with our reduced development activity. In light ofcurrent commodity prices and our revised drilling capital budget, we havesignificantly curtailed our production activities from the Barnett Shale, andwe do not expect volumes to return to prior levels during the remaining sixmonths of our 2009 Fiscal Year.  Also,higher gas production from the Cato Properties due to the aforementioneddevelopment activity was offset by lower gas production from our PanhandleProperties due to normal field decline of approximately 10% annually.

 

***Crude Oil and Natural Gas Prices***.  Theaverage price we receive for crude oil sales is generally at or above marketprices received at the wellhead, expect for the Cato Properties, for which wereceive below market prices due to its “sour” oil content. The average price wereceive for natural gas sales is approximately the market price received at thewellhead, adjusted for the value of natural gas liquids, less transportationand marketing expenses.  As discussed inNote 5, we have commodity derivatives in place that provide for $80 to $85crude oil “floor prices” and $7.75 to $8.00 natural gas “floor prices.” Ifcrude oil and natural gas NYMEX prices are lower than the “floor prices,” wewill be reimbursed by our counterparty for the difference between the NYMEXprice and “floor price.”

 

***Operating Expenses***

 

Forthe current quarter, our total operating expenses were $38.6 million, or $30.7million higher than the prior year quarter of $7.9 million. The primarycontributors to the increase were an impairment of long-lived assets of $22.4million and higher general and administrative expenses of $5.7 million.  Additionally, we experienced increased leaseoperating expenses of $2.1 million and higher depletion and depreciationexpense of $0.5 million.

 

Forthe current six months, our total operating expenses were $50.8 million, or$35.4 million higher than the prior year six months of $15.4 million. Theprimary contributors to the increase were from impairments of long-lived assetsof $22.4 million and higher general and administrative expenses of $7.0million.  Additionally, we experiencedincreased lease operating expenses of $4.6 million, higher depletion anddepreciation expense of $0.8 million and higher production and ad valorem taxesof $0.5 million.

 

Duringthe current quarter, we have recorded a pre-tax $22.4 million impairment on ourBarnett Shale Properties (Note 12).  Aspreviously discussed, in light of current commodity prices and our reviseddrilling capital budget, we believe there is uncertainty in the likelihood ofour developing proved undeveloped reserves associated with our Barnett ShaleProperties within the next five years. The fair value was determined using estimates of future productionvolumes, prices and operating expenses, discounted to a present value.

 

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

 

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·      For the current quarter, our LOE was $4.8million, which is $2.1 million higher than the prior year quarter.  The $2.1 million increase resulted primarilyfrom increased workover activities and increased downhole chemical treatmentsat the Panhandle Properties of $1.4 million and higher operating expensesincurred at the Cato Properties of $0.6 million to support increased crude oiland natural gas sales, as discussed under *“OperatingRevenues.”*The workover activities at the Panhandle Propertiespertained to returning wells to production and are expected to result inincreased production in future months. Based upon renegotiated contracts with the key service provider in thePanhandle Properties, LOE at the field is expected to be less over the comingquarters.  Additionally, based uponreduced activity at our Desdemona Properties we anticipate lower LOE at thefield.

 

·      For the current six months, our LOE was $9.8million, which is $4.6 million higher than the prior year six months.  We incurred higher LOE expenses at thePanhandle and Cato Properties of $3.1 million and $1.1 million, respectively,for the reasons previously discussed for the current quarter.

 

Forthe current quarter, our LOE per BOE, based on production, was $44.06 ascompared to $27.33 for the prior year quarter. For the current six months, our LOE per BOE, based on production, was$44.84 as compared to $26.28 for the prior year six months.  In general, secondary and tertiary LOE ishigher than the LOE for companies developing primary production because fieldsare more mature and typically produce less oil and more water.  We expectthe LOE to decrease during the 2009 Fiscal Year as we have successfullynegotiated service rate decreases with vendors, and we expect LOE per BOE to decreaseas production increases from the waterflood and EOR development activities wehave implemented and are implementing as discussed under the “*Drilling**CapitalDevelopment and Operating Activities Update.*”

 

***General and Administrative Expenses.***  Ourgeneral and administrative (G&A) expenses consist of support services forour operating activities and legal costs.

 

·      For the current quarter, our G&A expensestotaled $9.5 million, which is $5.7 million higher than the prior year quarterof $3.8 million. The primary reasons for the $5.7 million increase weresettlement costs, accruals for claims not settled at December 31, 2008 andhigher legal expenses pertaining to the fire litigation of $5.7 million asdiscussed in Note 13, increased legal costs associated with regulatorycompliance and costs associated with the stockholder lawsuit ($0.3 million).These G&A expenses were partially offset by decreased stock compensationexpense due to the lower cost of stock option grants of $0.3 million.

 

·      For the six months ended December 31,2008, our G&A expenses totaled $14.4 million, which is $7.0 million higherthan the prior year quarter of $7.4 million. The primary reasons for the $7.0million increase were settlement costs and higher legal expenses of $6.1million pertaining to the fire litigation as discussed in Note 13, increasedlegal costs associated with regulatory compliance and the stockholder lawsuitof $0.4 million, and increased payroll costs of $0.4 million due to increasedstaffing and labor costs.

 

Due to the settlements and accruals at December 31,2008 of fire litigation claims, as discussed in Note 13, we expect significantdecreases in legal expenses.

 

***Production and Ad Valorem Taxes***.  Forthe current quarter, our production and ad valorem taxes were $0.4 million,which is $0.1 million lower than the prior year quarter.  Our production taxes were lower by $0.2million due to reduced operating revenues, partially offset by increased advalorem taxes of $0.1 million.  For thecurrent six months, our production and ad valorem taxes were $1.5 million,which is $0.5 million higher than the prior year six months.  Our production taxes were higher by $0.1million due to increased operating revenues and increased ad valorem taxes of$0.4 million.  For both the currentquarter and current six months, the increased ad valorem taxes were due tonotification of revisions in tax property valuations by taxing authorities forthe 2008 calendar year.  Therefore, thecurrent six months includes higher tax rates for the six months plus a chargefor applying the rates to the first six months of the 2008 calendar year.

 

***Depletion and Depreciation Expense.***  Forthe current quarter, our depletion and depreciation expense was $1.4 million,or $0.5 million higher than the prior year quarter.  For the current sixmonths, our depletion and 

 

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depreciationexpense was $2.6 million, or $0.8 million higher than the prior year sixmonths.  This includes depletion expense pertaining to our oil and gasproperties, and depreciation expense pertaining to our field operationsvehicles and equipment, gas plant, office furniture and computers.  Forthe current quarter and current six months, our depletion rate per BOE pertainingto our oil and gas properties was $11.81 and $11.07, respectively, as comparedto prior year quarter and six months of $7.31 and $7.25, respectively.  The increased depletion rates resulted fromhigher rates for our Cato and Panhandle Properties based on our reserveredetermination at June 30, 2008 and periodic reassessments of depletionrates during the current six months.

 

***Interest Expense and Other***

 

Theinterest expense and other we incurred in the current quarter and current sixmonths of $0.1 million and $0.3 million, respectively, is comparable to therespective prior year periods.  Our interest expense for the current andprior year quarters is impacted by $0.1 million and $0.6 million, respectively,of interest cost that was capitalized to waterflood and ASP projects asdiscussed under the “*Drilling**Capital Development and Operating Activities Update.*”For the current and prior year six months, the capitalized interest coststotaled $0.6 million and $1.1 million, respectively.  We incurred higher interest costs during theprior year quarter and six months due to higher outstanding debt balances andhigher interest rates.

 

***Impairment of Goodwill***

 

Asdiscussed in Note 12, we recorded a $0.7 million pre-tax impairment of goodwillas a direct result of the $22.4 million pre-tax impairment on our Barnett ShaleProperties. The fair value was determined using estimates of future productionvolumes, prices and operating expenses, discounted to a present value.

 

***Unrealized Gain (Loss) on CommodityDerivatives***

 

Asdiscussed in Note 5, we have entered into financial contracts to set pricefloors for crude oil and natural gas, and to set price ceilings for crudeoil.  For the current quarter, we recorded an unrealized gain of $18.9million to reflect the fair value of the commodity derivatives as of December 31,2008.  For the prior year quarter, we recorded an unrealized loss of $1.8million.  For the current six months, we recorded an unrealized gain of$43.2 million as compared to an unrealized loss of $2.4 million for the prioryear six months.  By their nature, these commodity derivatives can behighly volatile to our earnings.  A five percent change in these pricesfor our derivative instruments can impact our pre-tax earnings by approximately$0.7 million.

 

***Realized Gain (Loss) on CommodityDerivatives***

 

Asdiscussed in Note 5, during the current year quarter, we had realized gains onour commodity derivatives amounting to $2.4 million versus $0 for the prioryear quarter.  For the current and prioryear six month periods, we had realized gains on our commodity derivatives of$1.8 million and $0.3 million, respectively. The current quarter and six months include a $0.7 million realized gainon the sale of floor-priced contracts as discussed in Note 5.  If crude oil and natural gas NYMEX prices arelower than the floor prices, we will be reimbursed by our counterparty for thedifference between the NYMEX price and floor price (i.e. realized gain).Conversely, if crude oil and natural gas NYMEX prices are higher than theceiling prices, we will pay our counterparty for the difference between theNYMEX price and floor price (i.e. realized loss).

 

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

 

Forthe current quarter, we recorded an income tax expense of $2.4 million ascompared to an income tax benefit of $0.3 million during the prior yearquarter.  For the current six months, we recorded an income tax expense of$10.6 million as compared to an income tax benefit of $0.5 million during theprior year six months.  These quarter and six months tax amounts includetaxes related to discontinued operations. The change is a direct result of the change in taxable income and anincrease in the current quarter’s state tax rate, resulting in an aggregaterate for the current quarter and current six months of 40.3% and 39.2%,respectively.  The income tax rate forthe prior year quarter and six months was 35.0% and 34.0%, respectively.

 

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***Preferred Stock Dividend***

 

Thepreferred stock dividend for the current quarter and current six months of $0.9million and $1.8 million, respectively, are comparable to the respective prioryear periods.  Due to redemption ofpreferred stock as discussed in Note 6, we expect the quarterly preferred stockdividends to decrease by approximately 45% in future quarters.

 

***Income from Discontinued Operations***

 

Forthe current and prior year quarters, we had income from discontinued operationsof $12.2 million and $0.7 million, respectively.  For the current and prior year six months, wehad income from discontinued operations of $11.4 million and $1.4 million,respectively.  This represents the incomeattributable to the divested Pantwist and Corsicana operations as discussed inNote 2.

 

***New Accounting Pronouncements***

 

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

 

InDecember 2007, the FASB issued SFAS No. 160, *Noncontrolling Interests in Consolidated FinancialStatements, an Amendment of ARB No. 51* (“SFAS No. 160”).SFAS No. 160 establishes accounting and reporting standards fornoncontrolling interests in a subsidiary and for the deconsolidation of asubsidiary. Minority interests will be recharacterized as noncontrollinginterests and classified as a component of equity. It also establishes a singlemethod of accounting for changes in a parent’s ownership interest in asubsidiary and requires expanded disclosures. This statement is effective forfiscal years beginning on or after December 15, 2008, with early adoptionprohibited. We will adopt SFAS No. 160 on July 1, 2009. We do notexpect the adoption of this statement will have a material impact on ourfinancial position, results of operations or cash flows.

 

InMarch 2008, the FASB issued SFAS No. 161, *Disclosures about Derivative Instruments and Hedging Activities—AnAmendment of FASB Statement 133* (“SFAS No. 161”). SFAS No. 161amends and expands SFAS No. 133 to enhance required disclosures regardingderivatives and hedging activities. It requires companies to provide additionaldisclosure to discuss the uses of derivative instruments; the accounting forderivative instruments and related hedged items under SFAS No. 133; andhow derivative instruments and related hedged items affect the company’sfinancial position, financial performance and cash flows. We will adopt SFAS No. 161on July 1, 2009. We do not expect the adoption of this statement will havea material impact on our financial position, results of operations or cashflows.

 

In December 2008, theFASB issued EITF********07-5, *Determining Whether anInstrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock* (“EITF 07-5”).  EITF07-5 affects companies that have provisions in their securities purchaseagreements (for warrants and convertible instruments) that resetissuance/conversion prices based upon new issuances by companies at pricesbelow the exercise price of said instrument. Warrants and convertible instruments with such provisions will requirethe embedded derivative instrument to be bifurcated and separately accountedfor as a derivative under SFAS No. 133. Subject to certain exceptions, our Series D convertible preferredstock provides for resetting the conversion price if we issue our common stockbelow $5.75 per share.  We are evaluatingthe effect of EITF 07-5 to ourfinancial position, results of operations or cash flows.  We will adopt EITF 07-5 on July 1, 2009.

 

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

 

SeeNotes 4, 5 and 11 regarding the updates of our market risk for the quarterended December 31, 2008.

 

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**Item 4. Controls and Procedures.**

 

Asof the end of the period covered by this report, we conducted an evaluation,under the supervision and with the participation of our chief executive officerand chief financial officer of our disclosure controls and procedures asdefined in Rule 13a-15(e) and Rule 15d-15(e) of theSecurities Exchange Act of 1934 (the “Exchange Act”). Based upon thisevaluation, our chief executive officer and chief financial officer concludedthat our disclosure controls and procedures were effective to ensure thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is: (1) accumulated and communicated to ourmanagement, including our chief executive officer and chief financial officer,as appropriate to allow timely decisions regarding required disclosure; and (2) recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

Duringthe quarter ended December 31, 2008, there was no change in our internalcontrol over financial reporting that has materially affected or is reasonablylikely to materially affect our internal control over financial reporting.

 

**PART II — OTHER INFORMATION**

 

**Item 1. Legal Proceedings.**

 

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

 

**Item 1A.  Risk Factors.**

 

Dueto the recent deterioration in the credit and equity markets, significantlylower crude oil and natural gas prices and certain settlements regarding thefire litigation, in our Quarterly Report on Form 10-Q for the quarterended September 30, 2008, we updated certain of the risk factors that wereincluded in our Annual Report on Form 10-K for the year-ended June 30,2008.  In this Quarterly Report on Form 10-Q,we have updated two of the risk factors from the Quarterly Report on Form 10-Qfor the quarter ended September 30, 2008 and have added an additionalfactor:

 

**Risks Related to Our Business**

 

***We are subject to many restrictionsunder our credit agreements which may adversely impact our future operations.***

 

We may depend on our credit agreements for future capital needs. Asrequired by our credit agreements with our bank lenders, we have pledgedsubstantially all of our oil and natural gas properties as collateral to securethe payment of our indebtedness. The credit agreements have certainrestrictions on our ability to obtain additional financing, make investments,sell assets, grant liens, repurchase, redeem or retire our securities, enterinto specific transactions with our subsidiaries or affiliates and engage inbusiness combinations. The credit agreements prohibit us from declaring orpaying dividends on our common stock. We are also required to comply withcertain financial covenants and ratios.

 

These financial covenants and ratios could limit our ability to obtainfuture financing, make needed capital expenditures, withstand a downturn in ourbusiness or the economy in general, including the current downturn in theeconomy, or otherwise conduct necessary corporate activities. We may also beprevented from taking advantage of business opportunities that arise because ofthe limitations that the restrictive covenants under the credit agreementsimpose on us. Although we are currently in compliance with these covenants, inthe past we have had to request waivers from or enter into amendments with ourlenders to avoid default because of our anticipated non-compliance with certainfinancial covenants and ratios. Any future default, if not cured or waived,could result in the acceleration of all indebtedness outstanding under thecredit agreements.  If that should occur,we may not be able to pay all such debt or to borrow sufficient funds torefinance it, which could force us to sell significant assets or to have ourassets foreclosed upon which could have a material adverse effect on ourbusiness or financial results. Even if new financing were available in light ofthe current credit market, it may not be on terms that are acceptable to us.

 

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In addition, the senior credit agreement limits the amounts we canborrow to a borrowing base amount, determined by the lenders, based uponprojected revenues from the oil and natural gas properties securing our loan.The lenders can independently adjust the borrowing base and the borrowingspermitted to be outstanding under the senior credit agreement.

 

***We are subject to two lawsuitsrelating to a fire that occurred on March 12, 2006 in Carson County, Texaswhich may have an adverse impact on us.***

 

Cano and certain of its subsidiaries were defendants in severallawsuits relating to a fire that occurred on March 12, 2006 in CarsonCounty, Texas and remain defendants in two of the lawsuits, one of which isbeing appealed by the plaintiffs after the trial court entered summary judgmentin our favor.  The plaintiffs allegeddamages include damage to land and livestock, remedial expenses and claimsrelating to wrongful death. We have settled all except the two remaininglawsuits.  Currently, known aggregateactual damage claims for both lawsuits are approximately $6,213,000.  However, the plaintiffs have not providedactual damage claims for all of their claims. These actual damage claims do not include the additional claims by theplaintiffs for attorneys’ fees and exemplary damages, the potential amounts ofwhich cannot be reasonably estimated.  InFebruary 2007, we entered into a Settlement Agreement with our insurancecarrier pursuant to which we received $6,699,827 in exchange for releasing theinsurance carrier from any future claims. $6,000,000 of the amount receivedrelated to the insurance policy limits and the remaining $699,827 related tothe reimbursement of defense costs previously incurred by Cano. The $6,000,000payment for policy limits, in accordance with the senior credit agreement, wasplaced in a controlled bank account and the use of the proceeds was specifiedto pay attorneys’ fees, settlement amounts, other litigation expenses incurredto defend and/or settle the fire litigation, and for general corporatepurposes. We have fully expended the $6,000,000 payment from fire litigationinsurance proceeds.  On October 11,2008, an independent electrical contractor committed to pay us $6,000,000 inexchange for a full release of any existing or future claims related towildfires that began on March 12, 2006 in Carson County, Texas.  This $6,000,000 was fully received by October 31,2008 and has been fully expended to cover portions of the settlements enteredinto to date.  There is no remaininginsurance coverage for the fire litigation. We may not be able to settle the lawsuits on acceptable terms and maynot prevail in court or on appeal on such cases.  If there is an adverse judgment entered againstus in one or more of the two remaining fire litigation cases, based on theilliquid nature of a significant portion of our assets, we may not be able to (i) posta sufficient supersedeas bond during the appeal process of any adversejudgment, which may permit the prevailing plaintiffs to attempt to execute onany judgment pending appeal, and/or (ii) satisfy the amount of any adversejudgment.

 

***Currently, our lease operatingexpense per BOE is high in comparison to the oil and natural gas industry as awhole.***

 

Until such time as we achieve production growth from our waterfloods,our lease operating expense per BOE should remain higher than standard for ourindustry as a whole.  The majority of ourproperties are in the late stage of the primary PDP production life-cycle.  With over 1,200 active wells, we areaveraging approximately 1 BOEPD per active well.  This level of LOE ($36.08 per barrel infiscal year 2008) is typical of the industry for this type of late stage PDPproduction profile.  Additionally, asmost of our expenses are fixed, LOE per BOEPD will remain high until such timeas responses (production lift) occur from our existing secondary waterfloodprojects and tertiary ASP projects. These higher operating costs have an adverse effect on our results ofoperations.

 

**Item 6. Exhibits.**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | First  Amendment to the Purchase and Sale Agreement by and among Cano  Petroleum, Inc., as Seller, and Legacy Reserves Operating LP, as Buyer,  and Pantwist, LLC, as the Company, dated October 1, 2008 (The schedules  and exhibits have been omitted from this filing. An exhibit to the schedules  and exhibits is contained in the First Amendment to the Purchase and Sale  Agreement and the schedules and exhibits are available to the Securities and  Exchange Commission upon request), incorporated by reference from  Exhibit 2.2 to Current Report on Form 8-K filed on October 6,  2008. |
| 3.1                 |       | Amendment  to Amended and Restated Bylaws, dated October 20, 2008, incorporated by  reference from Exhibit 3.1 to Current Report on Form 8-K filed on  October 24, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                     |

 

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| 10.1   |   | Summary  of 2009 Cash Incentive Awards., incorporated by reference from  Exhibit 3.1 to the Quarterly Report on Form 10-Q for the quarter ended  September 30, 2008.                                                                                                                                                                                                                          |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2   |   | Consulting  Agreement dated October 1, 2008 by and between Cano Petroleum, Inc.  and Morris B. Smith, incorporated by reference from Exhibit 10.1 to  Current Report on Form 8-K filed on October 6, 2008.                                                                                                                                                                          |
| 10.3   |   | Commitment  Letter by and among Union Bank of California, N.A. and Cano  Petroleum, Inc. dated November 19, 2008, incorporated by reference  from Exhibit 10.1 to Current Report on Form 8-K filed on  November 20, 2008.                                                                                                                                                           |
| 10.4   |   | Commitment  Letter by and among UnionBanCal Equities, Inc. and Cano  Petroleum, Inc. dated November 19, 2008, incorporated by reference  from Exhibit 10.2 to Current Report on Form 8-K filed on  November 20, 2008.                                                                                                                                                          |
| 10.5*  |   | Temporary  Waiver of Benefits by and among S. Jeffrey Johnson and Cano  Petroleum, Inc. dated October 28, 2008.                                                                                                                                                                                                                                                                                    |
| 10.6*  |   | First  Amendment to the Cano Petroleum, Inc. 2008 Annual Incentive Plan dated  October 20, 2008.                                                                                                                                                                                                                                                                                                   |
| 10.7*  |   | $120,000,000  Amended and Restated 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 dated December 17,  2008.                                                                                                                                                          |
| 10.8*  |   | $25,000,000  Subordinated Credit Agreement among Cano Petroleum, Inc. as Borrower,  The Lenders Party Hereto From Time to Time as Lenders, and UnionBanCal  Equities, Inc. as Administrative Agent and as Issuing Lender dated  December 17, 2008.                                                                                                                                            |
| 10.9*  |   | Amended  and Restated Guaranty Agreement dated as of December 17, 2008 by 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 Cano Petro of New Mexico, Inc. in favor of  Union Bank of California, N.A. as Administrative Agent.                                |
| 10.10* |   | Subordinated  Guaranty Agreement dated as of December 17, 2008 by 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 Cano Petro of New Mexico, Inc. in favor of  UnionBanCal Equities, Inc. as Administrative Agent.                                       |
| 10.11* |   | Amended  and Restated Pledge Agreement dated as of December 17, 2008 by and among  Cano Petroleum, Inc., WO Energy, Inc. and W.O. Energy of  Nevada, Inc. and Union Bank of California, N.A., as Administrative  Agent.                                                                                                                                                                  |
| 10.12* |   | Subordinated  Pledge Agreement dated as of December 17, 2008 by and among Cano  Petroleum, Inc., WO Energy, Inc. and W.O. Energy of  Nevada, Inc. and UnionBanCal Equities, Inc., as Administrative  Agent.                                                                                                                                                                         |
| 10.13* |   | Amended  and Restated Security Agreement dated as of December 17, 2008 by and 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. and Cano Petro of  New Mexico, Inc. and Union Bank of California, N.A., as Administrative  Agent. |
| 10.14* |   | Subordinated  Security Agreement dated as of December 17, 2008 by and 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. and Cano Petro of  New Mexico, Inc. and UnionBanCal Equities, Inc., as Administrative  Agent.        |
| 10.15* |   | Second  Amendment to Employment Agreement by and between Cano Petroleum, Inc.  and S. Jeffrey Johnson dated as of December 31, 2008.                                                                                                                                                                                                                                                               |
| 10.16* |   | First  Amendment to Employment Agreement by and between Cano Petroleum, Inc.  and Ben Daitch dated as of December 31, 2008.                                                                                                                                                                                                                                                                        |
| 10.17* |   | Fourth  Amendment to Employment Agreement by and between Cano Petroleum, Inc.  and Patrick M. McKinney dated as of December 31, 2008.                                                                                                                                                                                                                                                              |
| 10.18* |   | Fifth  Amendment to Employment Agreement by and between Cano Petroleum, Inc.  and Michael J. Ricketts dated as of December 31, 2008.                                                                                                                                                                                                                                                               |
| 10.19* |   | Second  Amendment to Employment Agreement by and between Cano Petroleum, Inc.  and Phillip Feiner dated as of December 31, 2008.                                                                                                                                                                                                                                                                   |
| 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.                                                                                                                                                                                               |

 

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

 

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

 

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**SIGNATURES**

 

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

 
| **CANO PETROLEUM, INC.**     |   |                                               |
|------------------------------|--------|----------------------------------------------------|
|                         |   |                                               |
| Date:  February 9, 2009 | By:    | /s/  S. Jeffrey Johnson                            |
|                         |   | S.  Jeffrey Johnson                                |
|                         |   | Chief  Executive Officer                           |
|                         |   |                                               |
|                         |   |                                               |
| Date:  February 9, 2009 | By:    | /s/  Benjamin Daitch                               |
|                         |   | Benjamin  Daitch                                   |
|                         |   | Senior  Vice-President and Chief Financial Officer |
|                         |   |                                               |
|                         |   |                                               |
| Date:  February 9, 2009 | By:    | /s/  Michael J. Ricketts                           |
|                         |   | Michael  J. Ricketts                               |
|                         |   | Vice-President  and Principal Accounting Officer   |

 

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