** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

----

**FORM 10-Q**
|                                                   | **(Mark  One)**                                                                                        |
|--------------------------------------------------------|--------------------------------------------------------------------------------------------------------|
| ** **                                             | ** **                                                                                             |
| **x**                                                  | ** QUARTERLY REPORT  UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                             | ** **                                                                                             |
| **For  the quarterly period ended September 30, 2007** |
| ** **                                             | ** **                                                                                             |
| **o**                                                  | ** TRANSITION REPORT  UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                   |

** **

**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) |
|                                      |
| **(817)  698-0900**                       |
| (Issuer’s  telephone number)         |

 

Indicate by checkmark whether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

Yes  x    No  o

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of acceleratedfiler and large accelerated filer in rule 12b-2 of the Exchange Act. (checkone):
| Large  accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|----------------------------|--------|----------------------|--------|--------------------------|

 

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

State the number of shares outstanding of each of theissuer’s classes of common equity, as of the latest practicable date: 36,982,217 shares of common stock, $.0001 par value per share, as of November7, 2007.

 

 

****

----

**PART I — FINANCIAL INFORMATION**

**Item 1. Financial Statements.**

**CANO PETROLEUM, INC.CONSOLIDATED BALANCE SHEETS**
| ***ASSETS***                                                                                                                                                                                                                                                  | ** **   | **September 30,** | ** **      | **June 30,** | ** **   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|-------------------|-----------------|--------------|--------------|
| ** **                                                                                                                                                                                                                                                    | ** **   | **2007**          | ** **      | **2007**     | ** **   |
| **Current  assets**                                                                                                                                                                                                                                           | ** **   | **(Unaudited)**   | ** **      | ** **   | ** **   |
| Cash and cash equivalents                                                                                                                                                                                                                                     |         | $                 | 583,842         |         | $            | 2,119,098 |   |
| Restricted cash (Notes 2, 11)                                                                                                                                                                                                                                 |         | 6,000,000         |            | —       |         |
| Accounts receivable                                                                                                                                                                                                                                           |         | 3,668,970         |            | 4,081,498    |         |
| Prepaid assets                                                                                                                                                                                                                                                |         | 822,463           |            | 309,216      |         |
| Derivative assets                                                                                                                                                                                                                                             |         | 422,513           |            | 810,174      |         |
| Inventory and other current assets                                                                                                                                                                                                                            |         | 308,631           |            | 292,540      |         |
| Total current assets                                                                                                                                                                                                                                          |         | 11,806,419        |            | 7,612,526    |         |
|                                                                                                                                                                                                                                                          |         |              |            |         |         |
| **Oil and gas properties****,**successful  efforts method                                                                                                                                                                                                     |         | 211,359,256       |            | 189,842,882  |         |
| Less accumulated depletion and depreciation                                                                                                                                                                                                                   |         | (7,281,156        | )               | (6,201,635   | )            |
| Net oil and gas properties                                                                                                                                                                                                                                    |         | 204,078,100       |            | 183,641,247  |         |
|                                                                                                                                                                                                                                                          |         |              |            |         |         |
| Fixed assets and other, net                                                                                                                                                                                                                                   |         | 1,541,278         |            | 1,547,875    |         |
| Restricted cash (Notes 2, 11)                                                                                                                                                                                                                                 |         | —            |            | 6,000,000    |         |
| Derivative assets                                                                                                                                                                                                                                             |         | 1,626,224         |            | 1,881,800    |         |
| Goodwill                                                                                                                                                                                                                                                      |         | 785,796           |            | 785,796      |         |
| **TOTAL ASSETS**                                                                                                                                                                                                                                              | ** **   | **$**             | **219,837,817** | ** **   | **$**        | **201,469,244** | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** **   | ** **        | ** **      | ** **   | ** **   |
| ***LIABILITIES  AND STOCKHOLDERS' EQUITY***                                                                                                                                                                                                                   | *** *** | *** ***      | *** ***    | *** *** | *** *** |
| **Current liabilities**                                                                                                                                                                                                                                       | ** **   | ** **        | ** **      | ** **   | ** **   |
| Accounts payable                                                                                                                                                                                                                                              |         | $                 | 10,563,376      |         | $            | 7,508,795 |   |
| Oil and gas sales payable                                                                                                                                                                                                                                     |         | 1,527,628         |            | 1,345,537    |         |
| Accrued liabilities                                                                                                                                                                                                                                           |         | 1,107,429         |            | 1,421,484    |         |
| Taxes payable                                                                                                                                                                                                                                                 |         | 535,343           |            | 450,062      |         |
| Current portion of asset retirement obligations                                                                                                                                                                                                               |         | 269,941           |            | 264,140      |         |
| Total current liabilities                                                                                                                                                                                                                                     |         | 14,003,717        |            | 10,990,018   |         |
| **Long-term liabilities**                                                                                                                                                                                                                                     | ** **   | ** **        | ** **      | ** **   | ** **   |
| Long-term debt                                                                                                                                                                                                                                                |         | 49,000,000        |            | 33,500,000   |         |
| Asset retirement obligations                                                                                                                                                                                                                                  |         | 2,174,525         |            | 2,150,930    |         |
| Deferred litigation credit (Note 11)                                                                                                                                                                                                                          |         | 6,000,000         |            | 6,000,000    |         |
| Deferred tax liability                                                                                                                                                                                                                                        |         | 32,228,000        |            | 32,371,000   |         |
| Total liabilities                                                                                                                                                                                                                                             |         | 103,406,242       |            | 85,011,948   |         |
|                                                                                                                                                                                                                                                          |         |              |            |         |         |
| **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 authorized and  49,116 shares issued; liquidation preference of $51,395,886 and $50,862,925, respectively.                 |         | 48,129,021        |            | 47,596,061   |         |
|                                                                                                                                                                                                                                                          |         |              |            |         |         |
| **Commitments and contingencies (Note 11)**                                                                                                                                                                                                                   | ** **   | ** **        | ** **      | ** **   | ** **   |
| **Stockholders' equity**                                                                                                                                                                                                                                      | ** **   | ** **        | ** **      | ** **   | ** **   |
| Common stock, par value $.0001 per share; 100,000,000 authorized;  34,351,392 and 33,083,098 shares issued and outstanding at September 30,  2007, respectively; and 33,956,392 and 32,688,098 shares issued and  outstanding at June 30, 2007, respectively. |         | 3,435             |            | 3,396        |         |
| Additional paid-in capital                                                                                                                                                                                                                                    |         | 85,924,948        |            | 85,238,362   |         |
| Accumulated deficit                                                                                                                                                                                                                                           |         | (17,055,097       | )               | (15,809,791  | )            |
| Treasury stock, at cost;  1,268,294 shares held in escrow                                                                                                                                                                                                     |         | (570,732          | )               | (570,732     | )            |
| Total stockholders' equity                                                                                                                                                                                                                                    |         | 68,302,554        |            | 68,861,235   |         |
| **TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                                                                                                                                                | ** **   | **$**             | **219,837,817** | ** **   | **$**        | **201,469,244** | ** ** |
| * *                                                                                                                                                                                                                                                      | * *     | * *          | * *        | * *     | * *     |

 

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

2

----

**CANO PETROLEUM, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**
| ** **                                                   | ** ** | **Three  Months Ended**

**September  30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                   | ** ** | ** **                                  |
|                                                         | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Operating Revenues:**                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Crude oil and natural gas sales                              |       | $                                           | 8,721,165  |   | $ | 7,674,800 |   |
|                                                         |       |                                        |       |   |   |
| **Operating Expenses:**                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Lease operating                                              |       | 3,102,998                                   |       | 2,771,731 |   |
| Production and ad valorem taxes                              |       | 699,356                                     |       | 618,711 |   |
| General and administrative                                   |       | 3,622,209                                   |       | 3,145,037 |   |
| Depletion and depreciation                                   |       | 1,134,669                                   |       | 976,952 |   |
| Accretion of discount on asset retirement obligations        |       | 54,402                                      |       | 28,891 |   |
| Total operating expenses                                     |       | 8,613,634                                   |       | 7,541,322 |   |
|                                                         |       |                                        |       |   |   |
| **Income from operations**                                   |       | 107,531                                     |       | 133,478 |   |
|                                                         |       |                                        |       |   |   |
| **Other income (expenses):**                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest expense                                             |       | (399,497                                    | )          | (1,842,714 | ) |
| Unrealized gain (loss) on commodity derivatives              |       | (516,037                                    | )          | 536,026 |   |
| Realized gain on commodity derivatives                       |       | 296,480                                     |       | 516,329 |   |
| Interest income                                              |       | 103,189                                     |       | 16,768 |   |
| Total other income (expenses)                                |       | (515,865                                    | )          | (773,591 | ) |
|                                                         |       |                                        |       |   |   |
| Income (loss) from continuing operations before income taxes |       | (408,334                                    | )          | (640,113 | ) |
|                                                         |       |                                        |       |   |   |
| Income tax benefit                                           |       | 130,000                                     |       | 197,200 |   |
|                                                         |       |                                        |       |   |   |
| **Income (loss) from continuing operations**                 |       | (278,334                                    | )          | (442,913 | ) |
| ** **                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Income from discontinued operations, net of taxes            |       | —                                      |       | 75,021 |   |
| ** **                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Net income (loss)**                                        |       | (278,334                                    | )          | (367,892 | ) |
| ** **                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Preferred stock dividend                                     |       | 966,972                                     |       | 268,604 |   |
| ** **                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Net loss applicable to common stock**                      |       | $                                           | (1,245,306 | ) | $ | (636,496 | ) |
|                                                         |       |                                        |       |   |   |
| **Net income (loss) per share - basic and diluted**          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Continuing operations                                        |       | $                                           | (0.04      | ) | $ | (0.02 | ) |
| Discontinued operations                                      |       | —                                      |       | — |   |
| **Net loss per share - basic and diluted**                   |       | $                                           | (0.04      | ) | $ | (0.02 | ) |
| ** **                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Weighted average common shares outstanding**               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Basic and diluted                                            |       | 32,615,815                                  |       | 26,043,250 |   |

 

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

 

3

----

**CANO PETROLEUM, INC.CONSOLIDATED STATEMENT OF CHANGESIN STOCKHOLDERS’ EQUITYJULY 1, 2007 THROUGH SEPTEMBER 30, 2007(Unaudited)**
| ** **                                   | ** ** | **Common  Stock** | ** ** | **Additional**

** Paid-in**

**Capital** | ** ** | **Accumulated**

**Deficit** | ** ** | **Treasury  Stock** | ** ** | ** ** | ** **      |
|----------------------------------------------|------------|-------------------|------------|------------------------------------------------|------------|------------------------------|------------|---------------------|------------|------------|-----------------|
| ** **                                   | ** ** | **Shares**        | ** ** | **Amount**                                     | ** ** | ** **                   | ** ** | **Shares**          | ** ** | **Amount** | ** **      | **Total** | ** ** |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| **Balance  at June 30, 2007**                | ** ** | **33,956,392**    | ** ** | **$**                                          | **3,396**  | ** **                   | **$**      | **85,238,362**      | ** ** | **$**      | **(15,809,791** | **)** | **1,268,294** | ** ** | **$** | **(570,732** | **)** | **$** | **68,861,235** | ** ** |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| Issuance of  restricted stock                |       | 395,000           |       | 39                                             |       | (39                          | )          | —              |       | —     |            | — |   | — |   |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| Stock based  compensation expense            |       | —            |       | —                                         |       | 583,374                      |       | —              |       | —     |            | — |   | 583,374 |   |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| Net proceeds from  issuance of common shares |       | —            |       | —                                         |       | 103,251                      |       | —              |       | —     |            | — |   | 103,251 |   |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| Preferred stock  dividend                    |       | —            |       | —                                         |       | —                       |       | (966,972            | )          | —     |            | — |   | (966,972 | ) |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| Net income                                   |       | —            |       | —                                         |       | —                       |       | (278,334            | )          | —     |            | — |   | (278,334 | ) |
|                                         |       |              |       |                                           |       |                         |       |                |       |       |            |   |   |   |   |
| **Balance  at September 30, 2007**           | ** ** | **34,351,392**    | ** ** | **$**                                          | **3,435**  | ** **                   | **$**      | **85,924,948**      | ** ** | **$**      | **(17,055,097** | **)** | **1,268,294** | ** ** | **$** | **(570,732** | **)** | **$** | **68,302,554** | ** ** |

 

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

 

4

----

**CANO PETROLEUM, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                                            | ** ** | **Three Months Ended September 30,** | ** **  |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------|-------------|
| ** **                                                                                            | ** ** | **2007**                             | ** **  | **2006** | ** ** |
| **Cash flow from operating activities:**                                                              | ** ** | ** **                           | ** **  | ** ** | ** ** |
| Net income (loss)                                                                                     |       | $                                    | (278,334    | ) | $ | (367,892 | ) |
| Adjustments needed to reconcile net income (loss) to net cash flow  provided by operating activities: |       |                                 |        |   |   |
| Unrealized loss (gain) on commodity derivatives                                                       |       | 516,037                              |        | (536,026 | ) |
| Accretion of discount on asset retirement obligations                                                 |       | 54,402                               |        | 33,444 |   |
| Depletion and depreciation                                                                            |       | 1,134,669                            |        | 1,015,164 |   |
| Stock based compensation expense                                                                      |       | 583,374                              |        | 218,693 |   |
| Deferred income tax expense (benefit)                                                                 |       | (143,000                             | )           | (155,000 | ) |
| Amortization of debt issuance costs and prepaid expenses                                              |       | 308,855                              |        | 923,255 |   |
|                                                                                                  |       |                                 |        |   |   |
| Changes in assets and liabilities relating to operations:                                             |       |                                 |        |   |   |
| Accounts receivable                                                                                   |       | 519,328                              |        | 515,781 |   |
| Derivative assets                                                                                     |       | 20,400                               |        | — |   |
| Prepaid assets                                                                                        |       | (755,249                             | )           | (332,323 | ) |
| Inventory                                                                                             |       | (16,226                              | )           | 60,115 |   |
| Accounts payable                                                                                      |       | (843,268                             | )           | (375,924 | ) |
| Oil and gas sales payable                                                                             |       | 182,091                              |        | (648,295 | ) |
| Accrued liabilities                                                                                   |       | (314,055                             | )           | 350,496 |   |
| Taxes payable                                                                                         |       | 85,281                               |        | 203,748 |   |
| Other current assets                                                                                  |       | —                               |        | (69,328 | ) |
| **Net cash provided by operating activities**                                                         | ** ** | **1,054,305**                        | ** **  | **835,908** | ** ** |
|                                                                                                  |       |                                 |        |   |   |
| **Cash flow from investing activities:**                                                              | ** ** | ** **                           | ** **  | ** ** | ** ** |
| Additions to oil and gas properties                                                                   |       | (17,643,531                          | )           | (1,952,219 | ) |
| Additions to fixed assets and other                                                                   |       | (35,269                              | )           | (369,875 | ) |
| Acquisition of additional Davenport revenue interest                                                  |       | —                               |        | (133,400 | ) |
| **Net cash used in investing activities**                                                             | ** ** | **(17,678,800**                      | **)**       | **(2,455,494** | **)** |
|                                                                                                  |       |                                 |        |   |   |
| **Cash flow from financing activities:**                                                              | ** ** | ** **                           | ** **  | ** ** | ** ** |
| Net borrowings (repayments) under Credit Agreement                                                    |       | 15,500,000                           |        | (68,750,000 | ) |
| Payment of debt issuance cost                                                                         |       | (80,000                              | )           | — |   |
| Payment of preferred stock dividends                                                                  |       | (434,012                             | )           | — |   |
| Proceeds from issuance of preferred stock, net                                                        |       | —                               |        | 46,269,287 |   |
| Proceeds from issuance of common stock and warrants, net                                              |       | 103,251                              |        | 29,937,533 |   |
| **Net cash provided by financing activities**                                                         | ** ** | **15,089,239**                       | ** **  | **7,456,820** | ** ** |
|                                                                                                  |       |                                 |        |   |   |
| Net increase in cash and cash equivalents                                                             |       | (1,535,256                           | )           | 5,837,234 |   |
| Cash and cash equivalents at beginning of period                                                      |       | 2,119,098                            |        | 644,659 |   |
| **Cash and cash equivalents at end of period**                                                        | ** ** | **$**                                | **583,842** | ** ** | **$** | **6,481,893** | ** ** |
| ** **                                                                                            | ** ** | ** **                           | ** **  | ** ** | ** ** |
| **Supplemental disclosure of noncash transactions:**                                                  | ** ** | ** **                           | ** **  | ** ** | ** ** |
| Payment of preferred stock dividends in kind                                                          |       | 532,960                              |        | 148,045 |   |
|                                                                                                  |       |                                 |        |   |   |
| **Supplemental disclosure of cash transactions:**                                                     | ** ** | ** **                           | ** **  | ** ** | ** ** |
| Cash paid during the period for interest                                                              |       | $                                    | 399,497     |   | $ | 2,196,081 |   |

 

***See accompanying notes to these unaudited financialstatements.***

 

5

----

**CANO PETROLEUM, INC.**

**NOTES TO FINANCIAL STATEMENTS**

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

The interim consolidated financial statements of CanoPetroleum, Inc. are unaudited and contain all adjustments (consistingprimarily of normal recurring accruals) necessary for a fair statement of theresults for the interim periods presented. Results for interim periods are notnecessarily indicative of results to be expected for a full year or forpreviously reported periods due in part, but not limited to, the volatility inprices for crude oil and natural gas, future commodity prices for commodityderivatives, interest rates, estimates of reserves, drilling risks, geologicalrisks, transportation restrictions, the timing of acquisitions, product demand,market competition, interruption in production, our ability to obtainadditional capital, and the success of waterflooding and enhanced oil recoverytechniques. You should read these consolidated interim financial statements inconjunction with the audited consolidated financial statements and notesthereto included in Cano’s Form 10-K dated June 30, 2007.

The accompanying financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of America (“GAAP”)and include the accounts of Cano and its wholly-owned subsidiaries.Intercompany accounts and transactions are eliminated. In preparing theaccompanying financial statements, management has made certain estimates andassumptions that affect reported amounts in the financial statements anddisclosures of contingencies. Actual results may differ from those estimates.Significant assumptions are required in the valuation of proved oil and naturalgas reserves, which may affect the amount at which oil and natural gasproperties are recorded. It is at least reasonably possible these estimatescould be revised in the near term, and these revisions could be material.

**New Accounting Pronouncements**

On July 13, 2006,the FASB released FIN 48, “Accounting for Uncertainty in Income Taxes—anInterpretation of FASB Statement 109” (“FIN 48”). FIN 48 requires companies toevaluate and disclose material uncertain tax positions it has taken withvarious taxing jurisdictions.  Anyinterest and penalties related to uncertain tax positions would be recorded asinterest expense and general and administrative expense, respectively.  We adopted FIN 48 on July 1, 2007.  At the time of adoption and as of September30, 2007, we determined the adoption of FIN 48 does not materially affect ouroperating results, financial position, or future cash flows.  As of September 30, 2007, we have notrecorded any accruals for uncertain tax positions.  We are not involved in any examinations bythe Internal Revenue Service.  For Texas,Oklahoma and U.S. federal purposes, the review of our tax returns is open forthe tax years of 2004, 2005 and 2006.  Wehave not yet filed our tax returns for 2007 tax year for Texas, Oklahoma, NewMexico and U.S. federal.

SFAS No. 157, *FairValue Measurements*, (“SFAS No. 157”) was issued by theFinancial Accounting Standards Board (“FASB”) in September 2006. SFASNo. 157 defines fair value, establishes a framework for measuring fairvalue under GAAP and expands disclosures about fair value measurements. SFASNo. 57 applies to other accounting pronouncements that require or permitfair value measurement. No new requirements are included in SFAS No. 157,but application of the SFAS No. 157 will change current practice. SFASNo. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007. We do not expect adoption of SFASNo. 157 will have a material impact on our financial position, results ofoperations or cash flows.

 

6

----

**2.   LONG-TERM DEBT**

At September 30, 2007 and June 30, 2007, theoutstanding amount due under the Credit Agreement was $49.0 million and$33.5 million, respectively.  The CreditAgreement is our only source of debt.  AtSeptember 30, 2007, the interest rate was 7.90%.

On September 7, 2007, we entered into Amendment No. 7 to the CreditAgreement, which provides for (i) an increase to our borrowing base from $44million to $60 million; (ii) permits us to use $6.0 million of the previouslyreceived insurance proceeds for general corporate purposes; and (iii) providesthat the leverage ratio (a) at the end of each fiscal quarter ending prior toJune 30, 2008 shall not be greater than 5.00 to 1.00; (b) at the end of eachfiscal quarter ending on or after June 30, 2008 but prior to December 31, 2008shall not be greater than 4.50 to 1.00; and (c) at the end of each fiscalquarter ending on or after December 31, 2008 shall not be greater than 4.00 to1.00 and for the purposes of calculating the leverage ratio, the definition of “consolidatedDebt” shall not include “Debt” outstanding under preferred stock.

Since Amendment No. 7 has made the Restricted Cash less restricted, wehave reclassified the Restricted Cash from a non-current asset to a currentasset at September 30, 2007. Specifically, we cannot use the Restricted Cash to fund capitalexpenditures.

At September 30, 2007, we were in compliance with theCredit Agreement debt covenants.

**3.   COMMODITYDERIVATIVES**

Pursuant to our Credit Agreement, we are required to enter intofinancial contracts to hedge a portion of our production at specified pricesfor oil and natural gas.  As of September30, 2007, these financial contracts are summarized in the table below. 
| **Time Period**             | ** ** | **Floor**

**Oil Price** | ** ** | **Barrels**

** per**

**Day** | ** ** | **Floor**

**Gas Price** | ** ** | **Gas Mcf**

**per Day** | ** ** | **Barrels of Equivalent Oil per Day** | ** ** |
|-----------------------------|------------|--------------------------|------------|-------------------------------------|------------|--------------------------|------------|-------------------------------|------------|--------------------------------------------|------------|
| 1/1/07 - 12/31/07 |       | $                        | 55         |                                | 507        |                     | $          | 8.00                          |       | 1,644                                      |       | 781 |   |
| 1/1/07 - 12/31/07 |       | $                        | 60         |                                | 72         |                     | $          | 7.60                          |       | 658                                        |       | 182 |   |
| 1/1/08 - 12/31/08 |       | $                        | 55         |                                | 479        |                     | $          | 7.50                          |       | 1,534                                      |       | 735 |   |
| 1/1/08 - 12/31/08 |       | $                        | 60         |                                | 66         |                     | $          | 7.60                          |       | 592                                        |       | 164 |   |
| 1/1/09 - 4/30/09  |       | $                        | 60         |                                | 59         |                     | $          | 7.60                          |       | 559                                        |       | 152 |   |
| 1/1/09 - 12/31/09 |       | $                        | 55         |                                | 395        |                     | $          | 7.60                          |       | 1,644                                      |       | 668 |   |
| 1/1/10 - 6/30/10  |       | $                        | 55         |                                | 365        |                     | $          | 7.00                          |       | 1,657                                      |       | 641 |   |
| 7/1/10 - 12/31/10           |       | $                        | 55         |                                | 395        |                     | $          | —                        |       | —                                     |       | 395 |   |
|                             |            |                          |            |                                     |            |                          |            |                               |            |                                            |            |  |  |  |

 
| **Time  Period**            |   |   | **Ceiling  Oil Price** |   | **Barrels**

**per   Day** |   |   | **Ceiling  Gas Price** |   | **Gas Mcf  per Day** |   | **Barrels of**

**Equivalent**

**Oil per Day** |   |
|-----------------------------|--------|--------|------------------------|--------|----------------------------|--------|--------|------------------------|--------|---------------------------|--------|------------------------------------------------------|--------|
| 8/1/07 - 12/31/07 |   | $      | 83                     |   | 493                        |   | $      | —                 |   | —                    |   | 493                                                  |   |
| 1/1/08 - 6/30/08  |   | $      | 86                     |   | 460                        |   | $      | —                 |   | —                    |   | 460                                                  |   |

 

During the quarters ended September 30, 2007 and2006, there were settlements under our commodity derivatives due to usamounting to $296,480 and $516,329, respectively, which are recorded asrealized gain on commodity derivatives on our consolidated statements ofoperations. The settlements were cumulative monthly payments due to us sincethe NYMEX natural gas price was lower than the “floor natural gas prices”ranging between $7.60 and $8.00. The cash flows relating to the derivativeinstruments are reflected in operating activities on our consolidatedstatements of cash flows. At September 30, 2007 and 2006, we had amountsdue from our counterparty of $106,800 and $280,144, respectively, included inour accounts receivable in our consolidated balance sheets.  We had no settlements under the crude oilprice ceilings through September 30, 2007.

 

7

----

We obtained mark-to-market valuations used for ourcommodity derivatives from an external source and validated such valuationsusing quotes for exchange-traded options with similar terms. During the quarterended September 30, 2007, we recognized unrealized loss on commodityderivatives on our consolidated statements of operations amounting to$516,037.  During the quarter endedSeptember 30, 2006, we had recognized an unrealized gain on commodityderivatives of $536,026.

**4.   ASSET RETIREMENT OBLIGATION**

Our financial statements reflect the provisions of Statement ofFinancial Accounting Standards No. 143,*Accounting for Asset Retirement Obligations*. Our asset retirementobligation (“ARO”) primarily represents the estimated present value of theamount we will incur to plug, abandon and remediate our producing properties atthe end of their productive lives, in accordance with applicable state laws. Wedetermine our ARO by calculating the present value of expected cash flowsrelated to the liability. Our asset retirement obligations are recorded ascurrent or non-current liabilities based on the estimated timing of theanticipated cash flows.  At September 30,2007, our liability for ARO was $2,444,466, of which $2,174,525 was consideredlong term.

The following table describes the changes in our asset retirementobligations for the three months ended September 30, 2007:
| Asset retirement obligation at June 30, 2007 |   | $       | 2,415,070 |   |
|---------------------------------------------------|--------|---------|-----------|--------|
| Accretion of discount                             |   | 54,402  |      |
| Liabilities settled                               |   | (25,006 | )         |
| Asset retirement obligation at September 30, 2007 |   | $       | 2,444,466 |   |

 

**5.   DEFERRED COMPENSATION**

As of September 30, 2007, we have issued 490,000 restricted shares tokey employees pursuant to our 2005 Long-Term Incentive Plan, as summarizedbelow:
| ** **                        | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date  Fair Value** | ** ** | **Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|-----------------------------------------------|------------|---------------------|------------|
| Outstanding at June 30, 2007      |       | 95,000     |       | $                                             | 5.59       |                | $          | 530,950 |   |
| Shares granted on July 2, 2007    |       | 395,000    |       | $                                             | 5.84       |                | $          | 2,306,800 |   |
| Outstanding at September 30, 2007 |       | 490,000    |       | $                                             | 5.79       |                | $          | 2,837,750 |   |

 

On July 2, 2007, we granted our executiveofficers restricted stock totaling 395,000 shares with the restrictions ontransfer lapsing for one-third of the shares on the first, second and thirdanniversaries of July 2, 2007.

 

A summary of the status of our non-vested restrictedshares and changes during the three months ended September 30, 2007 ispresented below:

 
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Grant-date   Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|------------------------------------------------|------------|
| Non-vested at June 30, 2007      |       | 75,000     |       | $                                              | 5.58       |   |
| Granted                          |       | 395,000    |       | 5.84                                           |       |
| Vested                           |       | (5,000     | )          | 5.03                                           |       |
| Forfeited                        |       | —     |       | —                                         |       |
| Non-vested at September 30, 2007 |       | 465,000    |       | $                                              | 5.81       |   |

 

The other restricted share grants will vest to theindividual employees based on future years of service ranging from one to threeyears depending on the life of the award agreement.  The fair value isbased our actual stock price on the date of grant multiplied by the number ofrestricted shares granted.  As of September 30, 2007, the value ofnon-vested restricted shares amounted to $2,700,200, which is 

8

----

anincrease of $2,281,650 as compared to the value for non-vested restrictedshares of $418,550 at June 30, 2007.  Theincrease is primarily attributable to the 395,000 shares granted on July 2,2007, as shown in the table above.  For the quarters ended September 30,2007 and 2006, we have expensed $350,083 and $93,377, respectively, to stockcompensation expense based on amortizing the fair value over the appropriateservice period.

**6.   STOCK OPTIONS**

On September 11, 2007, under the 2005 LTIP, 10,000 total options weregranted to an employee.  The exerciseprice is $5.95 per share.  The optionsvest on September 11, 2010 if this individual is still an employee on September11, 2010.

A summary of options as of September 30, 2007 is as follows:
| ** **                        | ** ** | **Shares** | ** ** | **Weighted Average  Exercise   Price** | ** ** |   |
|-----------------------------------|------------|------------|------------|----------------------------------------|------------|--------|
| Outstanding at June 30, 2007      |       | 801,513    |       | $                                      | 5.29       |   |
| Shares granted                    |       | 10,000     |       | $                                      | 5.95       |   |
| Outstanding at September 30, 2007 |       | 811,513    |       | $                                      | 5.30       |   |

 

Based on our $7.42 stock price at September 30, 2007,the intrinsic value of the options outstanding was approximately $608,000.

Total options exercisable at September 30, 2007amounted to 275,000 shares and had a weighted average exercise price of $5.21. At September 30, 2006, total options exercisable amounted to 200,000 shares andhad a weighted average exercise price of $4.06. Upon exercise, we issue the full amount of shares exercisable per theterm of the options from new shares. We have no plans to repurchase thoseshares in the future.

For the quarters ended September 30, 2007 and 2006, wehad recorded a charge to stock compensation expense of $233,291 and $125,316,respectively, for the estimated fair value of the options granted to ourdirectors and employees.

**7.   NET LOSS PER COMMON SHARE**

Basic net income (loss) per common share is computedby dividing the net income attributable to common shareholders by the weightedaverage number of shares of common stock outstanding during the period.

Diluted net income (loss) per common share is computedin the same manner, but also considers the effect of common stock sharesunderlying the following:
| ** **                   | ** ** | **September  30,** | ** ** |
|------------------------------|------------|--------------------|------------|
| ** **                   | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Stock options                | ** ** | 811,513            |       | 526,935 | ** ** |
| Warrants                     |       | 1,646,061          |       | 1,646,061 |   |
| Preferred stock              |       | 8,541,913          |       | 8,541,913 |   |
| PIK dividends                |       | 396,502            |       | 25,747 |   |
| Non-vested restricted shares |       | 465,000            |       | 145,000 |   |

 

The shares of common stock underlying the stockoptions, warrants, the preferred stock, PIK dividends and the restrictedshares, as shown in the preceding table, are not included in weighted averageshares outstanding for the three months ended September 30, 2007 and 2006 astheir effects would be anti-dilutive.

 

9

----

**8.   RELATED PARTYTRANSACTIONS**

Pursuant to an agreement dated December 16, 2004,we agreed with R.C. Boyd Enterprises, a Delaware corporation, to become thelead sponsor of a television production called Honey Hole (the “Honey HoleProduction”). For the quarters ended September 30, 2007 and 2006, we paid anaggregate of $37,500 to R.C. Boyd Enterprises during both quarters.  From July 1, 2007 throughDecember 31, 2008, we are to pay an aggregate of $225,000 ($37,500 perquarter). After December 31, 2008, we will no longer be a Honey HoleProduction sponsor. We are entitled to receive two thirty second commercialsduring all broadcasts of the Honey Hole Production and receive opening andclosing credits on each episode. As part of our sponsorship, we are able toprovide fishing and outdoor opportunities for children with cancer, childrenfrom abusive family situations and military veterans. Randall Boyd, one of ourcurrent directors, is the sole shareholder of R.C. Boyd Enterprises.

**9.   PREFERREDSTOCK CONVERSION**

On October 17, 2007, 2,000 shares of our Series DConvertible Preferred Stock (“Preferred Stock”) were converted into 349,119shares of our common stock. The issued common shares consisted of 348,126shares based on the $5.75 conversion price of the Preferred Stock and 1,293shares in lieu of the accrued but unpaid dividends from October 1, 2007 toOctober 17, 2007 pursuant to the terms of the Preferred Stock. The shares ofCano common stock were issued in reliance upon the exemption from registrationprovided by Section 3(a)(9) of the Securities Act of 1933.

 

As a direct result of this conversion, as of October17, 2007, our preferred shares issued are 47,116 shares and the liquidationpreference is $49,571,097.

 

**10.   COMMON STOCKISSUANCE**

On November 7, 2007, we sold in a private placement3.5 million shares of our common stock at $7.15 per share for gross proceeds of$25 million.  Net proceeds were $23.2million after deducting issuance costs of $1.8 million. The net proceeds willbe initially used to pay down our long-term debt due under the Credit Agreementand subsequently drawn down to fund our capital development program and generalcorporate purposes.

 

**11.   COMMITMENTSAND CONTINGENCIES**

***Fire Litigation***

*BurnettCase*

On March 23, 2006, the following lawsuit was filedin the 100th Judicial District Court in Carson County, Texas; CauseNo. 9840, The Tom L. and Anne Burnett Trust, by Anne Burnett Windfohr,Windi Phillips, Ben Fortson, Jr., George Beggs, III and Ed Hudson, Jr. asCo-Trustees; Anne Burnett Windfohr; and Burnett Ranches, Ltd. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd, and WO Energy, Inc. The plaintiffs claim that the electricalwiring and equipment of Cano or certain of its subsidiaries relating to oil andnatural gas operations started a wildfire that began on March 12, 2006 inCarson County.

 

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

 

 

 

10

----

 

*Other Cases*

 

On April 28, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas,Case No. 1922, Robert and Glenda Adcock, et al. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd, and WO Energy, Inc. (“Adcock”).

 

On April 10, 2006, the following lawsuit wasfiled in the 31st Judicial District Court of Roberts County, Texas, CaseNo. 1920, Joseph Craig Hutchison and Judy Hutchison v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd, and WO Energy, Inc. (“Hutchinson”). On October 3,2007, Firstbank Southwest, as Trustee for the John and Eddalee Haggard Trust(the “Trust”) filed a Petition in intervention as part of the Hutchisoncase.  The Trust claims that CanoPetroleum, Inc. or certain of its subsidiaries failed to operate and maintainthe electric transmission and distribution lines in a reasonable and safecondition and proximately caused a wildfire that began on March 12, 2006 inCarson County.  The Trust allegesnegligence and seeks undisclosed damages, including, but not limited to, damagesto the land and certain remedial expenses.

 

On May 1, 2006, the following lawsuit was filedin the 31st Judicial District Court of Roberts County, Texas, CaseNo. 1923, Chisum Family Partnership, Ltd. v. Cano, W.O. Energy ofNevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc. (“Chisum”).

 

On July 3, 2006, the following lawsuit was filedin the 31st Judicial District Court of Roberts County, Texas, CaseNo. 1928, Rebecca Lee Martinez, et al v. Cano Petroleum, Inc., W.O.Energy of Nevada, Inc., W. O. Operating Company, Ltd., and WO Energy,Inc. (“Martinez”).

 

On August 9, 2006, the following lawsuit wasfiled in the 233rd Judicial District Court of Gray County, Texas, YolandaVillareal, Individually and on behalf of the Estate of Gerardo Villareal v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd., and WO Energy, Inc. (“Villareal”).

 

On March 14, 2007, the following lawsuit wasfiled in 100th Judicial District Court in Carson County, Texas; CauseNo. 9994, Southwestern Public Service Company d/b/a Xcel Energy v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd, and WO Energy, Inc. (“SPS”).

 

On May 2, 2007, the following lawsuit was filedin the 84th Judicial District Court of Hutchinson County, Texas,Case No. 37,619, Gary and Genia Burgess, et al. v. CanoPetroleum, Inc., W.O. Energy of Nevada, Inc., W.O.Operating, Ltd. and WO Energy, Inc. (“Burgess”).

 

On August 28, 2007, one of the intervenors to theAdcock case, Travelers Lloyds Insurance Company, filed a Notice ofNonsuit requesting the court to sign an order dismissing its claims, which seekapproximately $367,627 of total damages, without prejudice.  The Court granted the Non-suit on September12, 2007.

 

On September 25, 2007, the Texas Judicial Panel onMultidistrict Litigation granted Cano Petroleum, Inc., W.O. Energy ofNevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc.’sMotion to Transfer Related Cases to Pretrial Court pursuant to Texas Rule ofJudicial Administration 13.  The Paneltransferred to a single pretrial court for consideration of pretrial matters ofall pending cases (Adcock, Chisum, Hutchison, Villareal,Martinez, SPS, Burgess, identified above) that assertclaims against the Company and its subsidiaries related to wildfires beginningon March 12, 2006.  The Panel transferred all pending cases to theHonorable Paul Davis, retired judge of the 200th District Court of TravisCounty, Texas.  On October 19, 2007, the Court entered a Case ManagementOrder setting deadlines for completion of discovery in January and February of2008 and a hearing date for summary judgment motions on April 14, 2008.

 

Due to the inherent risk of litigation, the outcome ofthese cases is uncertain and unpredictable; however, at this time, Canomanagement believes the suits are without merit and is vigorously defendingitself and its subsidiaries.

 

11

----

***Insurance Settlement***

As discussed in our Form 10-K dated June 30, 2007,during February 2007, we received a $6,699,827 payment from Mid-ContinentCasualty Company for policy limits totaling $6,000,000 and defense coststotaling $699,827. The $6,000,000 payment for policy limits, in accordance withthe Credit Agreement (Note 2), have been placed in a controlled bankaccount and the use of the proceeds is specified to pay attorney’s fees,settlement amounts, other litigation expenses incurred to defend and/or settlethe fire litigation, and for general corporate purposes. Specifically, wecannot use the proceeds to fund capital expenditures.  Accordingly, our consolidated balance sheetsreflect the $6,000,000 as restricted cash and a corresponding liability underdeferred litigation credit.

 

***Other***

Occasionally, we are involved in other variouslawsuits and certain governmental proceedings arising in the ordinary course ofbusiness. Our management does not believe that the ultimate resolution of anycurrent matters that are not set forth above, will have a material effect onour financial position or results of operations.  Management’s position is supported, in part,by the existence of insurance coverage, indemnification and escrowaccounts.  None of our directors,officers or affiliates, owners of record or beneficial owners of more than fivepercent of any class of our voting securities, or security holder is involvedin a proceeding adverse to our business or has a material interest adverse toour business.

***Environmental***

To date, our expenditures to comply with environmentalor safety regulations have not been significant and are not expected to besignificant in the future. However, new regulations, enforcement policies,claims for damages or other events could result in significant future costs.

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

**Forward-Looking Statements**

The information in this report on Form 10-Qcontains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. This Act provides a “safe harbor”for forward-looking statements to encourage companies to provide prospectiveinformation about themselves provided they identify these statements as forwardlooking and provide meaningful cautionary statements identifying importantfactors that could cause actual results to differ from the projected results.All statements other than statements of historical fact made in this report areforward looking. In particular, the statements herein regarding industryprospects and future results of operations or financial position areforward-looking statements. Forward-looking statements reflect management’scurrent expectations and are inherently uncertain. Our actual resultsmay differ significantly from management’s expectations as a result of manyfactors, including, but not limited to the volatility in prices for crude oiland natural gas, future commodity prices for derivative hedging contracts,interest rates, estimates of reserves, drilling risks, geological risks,transportation restrictions, the timing of acquisitions, product demand, marketcompetition, interruption in production, our ability to obtain additionalcapital, and the success of waterflooding and enhanced oil recovery techniques.

You should read the following discussion and analysisin conjunction with the consolidated financial statements of CanoPetroleum, Inc. and subsidiaries and notes thereto, included herewith.This discussion should not be construed to imply that the results discussedherein will necessarily continue into the future, or that any conclusionreached herein will necessarily be indicative of actual operating results inthe future. Such discussion represents only the best present assessment ofmanagement.

**Growth Strategy**

We are a growing independent oil and natural gascompany that intends to actively pursue enhanced oil recovery techniques toincrease production and reserves at our existing properties and propertiesacquired 

 

12

----

in thefuture.  Our primary focus is crude oil and our target acquisitions areonshore U.S. properties.  Our focus on domestic, mature oil fieldseliminates exploration risks and uncertainties of international sources. We use waterflooding and enhanced oil recovery methods (“EOR”), such asalkaline/ surfactant/ polymer (“ASP”) technology.

During our first two years of operations throughJune 30, 2006, our primary focus was to achieve growth through acquiringexisting, mature oil and natural gas fields. In March 2007, we acquiredPermian Basin oil and natural gas properties located in New Mexico. We believethe portfolio of oil and natural gas properties that we have acquired thus farprovides ample opportunities to apply our operational strategy. As ofJune 30, 2007, we had proved reserves of 66,720 MBOE, of which 8,454 MBOEwere proved producing, 2,843 MBOE were proved non-producing, and 55,423 MBOEwere proved undeveloped.

During the fiscal year ended June 30, 2007 andcontinuing into our current fiscal year ending June 30, 2008 (“2008 Fiscal Year”),our primary emphasis is to achieve growth by developing our existing oil andnatural gas properties through development activities such as waterflooding andEOR technology. We will continue to evaluate potential acquisition targets thatare consistent with our operational strategy. These development activities aremore clearly defined in the next section titled “Capital Development Update.”

***Capital DevelopmentUpdate***

For the 2008 Fiscal Year, our initial capitaldevelopment budget was $57 million. Of this amount, we have incurred $21.5 million, of which $17.6 millionhas been spent, for the three months ended September 30, 2007.  As a result of the $23.2 million we receivedfrom the recently completed private placement common stock sale as discussed inNote 10, our 2008 Fiscal Year capital budget has been increased from $57million to $78 million. The $21 million increase consists of $14 million to beused for new well drilling, $3 million to be allocated for facilities and $4million for acquisitions.  We haveaccelerated our capital development in the Panhandle waterflood and the CatoField, and have increased our capital spending to handle the increased gasproduction from the Barnett Shale in our Desdemona Field.  The status and planned activity of ourcapital development for the 2008 Fiscal Year is summarized as follows:

***        PanhandleProperties.***    The drilling of the final contingent of 32 replacementwaterflood wells was completed in the quarter ended September 30, 2007, onemonth ahead of schedule. In total, we have drilled 70 replacement wells in thefield, which represents the completion of the development patterns of thewaterflood project. Water injection was initiated at the Cockrell Ranch Unit onJuly 5, 2007.  At the present time, 31injection wells are delivering over 21,000 barrels of water per day into theBrown Dolomite formation.  In total, we have injected close to one millionbarrels of water into the reservoir. As we continue bringing additionalinjection wells to active status, we anticipate achieving the full 75 wellinjection pattern by late-November 2007 with a maximum injection rate of 52,500barrels of water per day. Currently, 71 producing wells are active and awaitinginitial response. Preliminary response from the waterflood is anticipated inthe December 2007-January 2008 timeframe. Full waterflood development over the remaining 11,000+ net acres of thePanhandle Properties is anticipated once the initial response data is available.

As part of the accelerated waterflood development, anadditional 61 total wells will be drilled at the Panhandle Field encompassing36 wells at the waterflood expansion at the Harvey Unit and 25 wells toaccelerate waterflood development at the Mobil-Fee Unit. Including theincremental $10 million received from the sale of common shares as discussed inNote 10, the total 2008 Fiscal Year capital budget for the Panhandle Propertiesis $31 million.

***        DesdemonaProperties—Waterflood.    ***We received the final approval of ourPhase I waterflood permit for the 640 acre G.E. Moore Lease from the TexasRailroad Commission on September 11, 2007. Water injection commenced shortly thereafter and in total, we haveaveraged 7,000 barrels of water injected per day, or over 350,000 barrels of waterin total, into the Duke Sandstone reservoir via six injection wells.  We currently have 11 producing wells andanticipate an initial waterflood response in the first calendar quarter of2008.

 

13

----

***        DesdemonaProperties—Barnett Shale.    ***Severe storms and flooding in theDesdemona Field in late June 2007 and early July 2007 curtailed our BarnettShale production to one-half of the previous levels or roughly 600 MCFPD. Forthe quarter ended September 30, 2007, it is estimated that production was downby approximately 120 BOEPD or 720 MCFPD. Equipment repairs and well re-workswere completed in July and August 2007, and production was not restored toprior levels until late September.  Wehave drilled and completed 4 horizontal wells out of the announced 2008 FiscalYear budget of 24 horizontal wells in the field.  Total Barnett Shale production from the fieldis currently averaging 1.4 MMCFPD.

In response to currently low natural gas prices, wehave elected to defer the drilling program in the Barnett Shale. Of theremaining capital amount of roughly $15 million committed to this program,roughly $5 million will be re-directed to the Cato Field and the remainingbalance of $10 million could be committed to the Barnett Shale program oncenatural gas prices improve.

***        NowataProperties.***    Ourtertiary recovery pilot project at the Nowata Field is operational.  The ASP pilot plant, associated equipment andsupplies were installed and tested during August and September 2007.  FullASP Plant operations are scheduled to begin in November 2007. Response isanticipated in the second calendar quarter of 2008.

***        CorsicanaProperties.***    Wehave drilled and completed 16 pattern replacement wells and plan to reinstate aprior waterflood in this field. We received the required permits to injectwater in June 2007. We are planning to reinstate the prior waterflood inNovember 2007. As we previously mentioned, we have been pleased with theremaining oil saturations in this field and coupled with the prior successfulpolymer pilot in this field in the 1980’s we believe this field is a prime ASPcandidate. Once the waterflood response and laboratory results are analyzed, weanticipate evaluating an ASP Pilot in the field in calendar year 2008.

***        NewMexico Properties.***    We completed the acquisition of the New MexicoProperties on March 30, 2007.  As mentioned previously, $5 million ofadditional capital is being re-deployed to these properties and including theincremental $11 million from the sale of common shares as discussed in Note 10,the revised 2008 Fiscal Year capital budget is $26 million for the New MexicoProperties.  The capital spending amountis being increased based on better than expected initial results fromreturn-to-production (RTP’s) workovers and re-frac stimulations performed inthe Cato Field, the largest of the three fields comprising our New MexicoProperties.  We have a three prongedapproach to develop the San Andres formation in this field:

1.               **Return-to-Production andRe-frac Stimulations**: We have worked over 40 idle wells and have currently returned 24wells to production. We plan to RTP between 60-80 wells during the course ofthe 2008 Fiscal Year. We have deployed re-frac stimulations on six RTP wells inthe Cato Field.  Initial productionresponses of between 5-20 BOEPD per well have been achieved.  It is our goal to re-frac up to 25 of the RTPwells during the course of the year. Production in the Cato Field has increasedfrom 45 BOEPD when we assumed operations in April 2007 to current production ofover 90 BOEPD.

2.               **New Well Drilling**: One drilling rig was moved to the CatoField on October 22, 2007, and we spudded the first of 11 new 40-acre spacedwells in areas of the Cato Field that have not been developed. We anticipateinitial production in the range of 20-40 BOEPD based on cumulative productionhistories of adjacent wells.  These wellsare relatively shallow at 3,500 feet and drilling and completion costs areestimated to be less than $300,000 per well.

3.               **20-Acre Infill Drilling**: One drilling rig has been contracted todrill 21 new 20-acre infill wells in an area of the Cato Field that had a priorwaterflood pilot.  The first rig will spudin November 2007 and the second rig is expected to be secured by January2008.  All the drilling is expected to becompleted by June 2008.  Similar toinfill results reported by other operators in their analogs of developmentactivity within the San Andres formation, we expect initial production in therange of 15-25 BOEPD from this program. Initiation of Phase I of the waterflood at the Cato Field is scheduledfor the second calendar quarter of 2008.

14

----

We have no major development activities planned foreither the Davenport or Pantwist Properties during the 2008 Fiscal Year.

**Liquidity and Capital Resources**

As discussed in Note 2, our credit agreement wasamended to increase our borrowing base from $48 million to $60 million. At September 30, 2007, we had outstanding long-term debt of $49 million and theaverage interest rate was 7.90%.  Thecredit agreement is our only source of debt.

At September 30, 2007, our cash balance was $0.6million.  For the three months ended September 30, 2007, we generated cashfrom operations of $1.0 million, which is a slight improvement of $0.2 millionas compared to the three months ended September 30, 2006 due to increasedincome from operations.  As discussed inNote 2, the amended credit agreement relaxes the restrictions of the $6.0million of restricted cash to permit use for general corporate purposes, inaddition to attorney’s fees, settlement amounts and other litigation expensesincurred to defend and or settle the fire litigation discussed in Note 11.  Specifically, we cannot use the restrictedcash to fund capital expenditures.

As discussed in Note 10, on November 7, 2007, wereceived net proceeds of $23.2 million from the private placement issuance of3.5 million shares of our common stock. The net proceeds will be initially used to pay down our long-term debtdue under the Credit Agreement and subsequently drawn down to fund our capitaldevelopment program as previously discussed under “*Capital Development Update*” and for generalcorporate purposes.

We believe the combination of cash on hand, restrictedcash, cash flow generated from operations, strong commodity prices, netproceeds from the November 7, 2007 private placement issuance and availabledebt is sufficient to finance our operations, contractual obligations andcapital expenditure program (as previously discussed in the section titled “*Capital Development Update”)* through June 30, 2008.  We expect to seek access to the capitalmarkets for potential debt or equity issuances to finance the execution andacceleration of our capital development plan.

***Hedging Activities***

As discussed in Note 3, pursuant to our creditagreement, we are required to enter into financial contracts to hedge ourexposure to commodity price risk associated with expected oil and natural gasproduction. We have purchased crude oil price floors that range from $55 -$60 per barrel through December 2010.  Wehave purchased natural gas price floors that range from $7.00 - $8.00 per Mcfthrough June 2010.  For the three months ended September 30, 2007,approximately 69% of our sales were hedged with price floors.

During the three months ended September 30, 2007, weentered into financial contracts to sell crude oil price ceilings at $83 per barrelfrom August through December 2007, and $86 per barrel from January through June2008.  For the three months endedSeptember 30, 2007, approximately 23% of our sales were subject to priceceilings.  We had no settlements underthe crude oil price ceilings through September 30, 2007.

We entered into these short-term financial contractsto sell price ceilings in order to offset the costs of price floors we purchaseto comply with our Credit Agreement which requires we are to maintain hedges tocover no less than 50% and no more than 80% of our production volumesattributable to proved producing reserves for three years.  Except for the price ceilings, we areentitled to 100% of our revenue receipts and, if crude oil and natural gasNYMEX prices are lower than the price floor, we will be reimbursed for thedifference between the NYMEX price and floor price.

 

15

----

**Results of Operations**

For the quarter ended September 30, 2007 (“current quarter”), we had aloss applicable to common stock of $1.2 million, which was $0.6 million higheras compared to the $0.6 million loss applicable to common stock incurred forthe quarter ended September 30, 2006 (“prior year quarter”).  Positive factors including increased revenuesof $1.0 million and lower interest expense of $1.4 million were more thanoffset by higher operating expenses of $1.1 million, reduced valuation ofcommodity derivatives of $1.1 million, higher preferred stock dividend of $0.7million, and lower realized gain on commodity derivatives of $0.2 million.

These items will be addressed in the following discussion.

***Operating Revenues***

The table below summarizes our operating revenues forthe quarters ended September 30, 2007 and 2006.
| ** **                      | ** ** | **Quarter Ended September 30,** | ** ** | **Increase**

**(Decrease)** | ** ** |
|---------------------------------|------------|------------------------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | **2007**                                       | ** ** | **2006**                     | ** ** | ** ** |
| Operating Revenues              |       | $                                              | 8,721,165  |                         | $          | 7,674,800 |   | $ | 1,046,365 |   |
| Sales                           |       |                                           |       |                         |       |   |   |
| •  Oil  (MBbls)  |       | 69                                             |       | 70                           |       | (1 | ) |
| •  Gas  (MMcf)   |       | 352                                            |       | 330                          |       | 22 |   |
| •  Total  (MBOE) |       | 127                                            |       | 125                          |       | 2 |   |
| Average Price                   |       |                                           |       |                         |       |   |   |
| •  Oil  ($/ Bbl) |       | $                                              | 72.55      |                         | $          | 69.19 |   | $ | 3.36 |   |
| •  Gas  ($/ Mcf) |       | $                                              | 10.37      |                         | $          | 8.56 |   | $ | 1.81 |   |

 

The current quarter operating revenues of $8.7 millionrepresent an improvement of $1.0 million as compared to the prior year quarterof $7.7 million. The $1.0 million improvement is primarily attributable toincreased gas sales of $0.6 million and higher prices received for crude oiland natural gas sales of $0.5 million; partially offset by lower oil sales of$0.1 million.  The increased gas salesoccurred primarily from the Barnett Shale production from our DesdemonaProperties, partially offset by lower production from the Panhandle andPantwist Properties as severe storms temporarily shut-in production.  Overall, for the current quarter, the severestorms impacted our total oil and gas production by approximately 220 net BOEPDat the Panhandle, Pantwist and Desdemona Properties.  The average price we received for crude oilsales is generally at or above market prices received at the wellhead. Theaverage price we receive for natural gas sales is approximately the marketprice received at the wellhead less transportation and marketing expenses.

***Operating Expenses***

For the current quarter, our total operating expenseswere $8.6, or $1.1 million higher than the prior year quarter of $7.5 million.The $1.1 million increase is primarily attributed to higher general andadministrative expenses of $0.5 million, increased lease operating expenses of$0.3 million, higher depletion and depreciation expense of $0.2 million andhigher other operating expenses of $0.1 million.

Our lease operating expenses (“LOE”) consists of costsof producing crude oil and natural gas such as labor, supplies, repairs,maintenance, and utilities. For the current quarter, the LOE per BOE was $23.91as compared to $21.75 per LOE for the prior year quarter.  The increase isdue to higher LOE incurred primarily attributed to the weather relatedoutages.  We generally incur a highamount of LOE because our fields are more mature and typically produce less oiland more water, and they are generally at the end of the primary or secondaryproduction cycle.  We expect the LOE perBOE to decrease during the 2008 Fiscal Year as production increases from thewaterflood and EOR development activities we are implementing as discussedunder the *“Capital Development Update*.”

 

16

----

Our general and administrative (G&A) expensesconsist of support services for our operating activities and investor relationscosts. For the current quarter, our G&A expenses totaled $3.6 million,which is $0.5 million higher than the prior year quarter of $3.1 million. Theprimary reasons for the $0.5 million increase were increased stock compensationexpense due to the issuance of restricted shares as discussed in Note 5 andhigher legal expenses pertaining to the fire litigation as discussed in Note11.

For the current quarter, our depletion anddepreciation expense was $1.1 million, or $0.2 million higher than the prioryear quarter.  This includes depletionexpense pertaining to our oil and gas properties, and depreciation expensepertaining to our field operations vehicles and equipment, gas plant, officefurniture and computers.  For the currentquarter, our depletion rate pertaining to our oil and gas properties was $7.34per barrel of oil equivalent (“BOE”), as compared to prior year quarter of$6.57 per BOE due to lower proved producing reserves for the PanhandleProperties, acquisition of the New Mexico Properties and the depletion rateassociated with the gas production from the Barnett Shale.

***Interest Expense***

The interest expense we incurred in the currentquarter of $0.4 million is $1.4 million lower than the prior year quarter.  This is primarily due to lower debtbalances.  During the prior year quarter,we had a debt balance of $68.75 million outstanding until September 6, 2006,which was fully repaid with proceeds from the preferred and common stockissuance.  Also, our current quarterinterest expense is impacted by $0.5 million of interest cost that wascapitalized to waterflood and ASP projects as discussed under the *“Capital Development Update.”*

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

As discussed in Note 3, we have entered into financial contracts to setprice floors for crude oil and natural gas, and to set price ceilings for crudeoil.  For the current quarter, werecorded an unrealized loss of $0.5 million to reflect the fair value of thecommodity derivatives as of September 30, 2007. For the prior year quarter, we recorded an unrealized gain of $0.5million.  By their nature, thesecommodity derivatives can be highly volatile to our earnings.  A five percent change in these prices for ourderivative instruments can impact earnings by approximately $0.1 million.

***Gain on HedgingContracts***

During the current and prior year quarters, there were settlementsunder our derivative agreements due to Cano amounting to $0.3 million and $0.5million, respectively. The settlements were cumulative monthly payments due toCano since the NYMEX gas price was lower than the $8.00 and $7.60 “floornatural gas prices,” as discussed in Note 3.

***Income Tax Benefit***

For the current quarter,we recorded an income tax benefit of $130,000 as compared to an income taxbenefit of $197,200 during the prior year quarter.  The change is a directresult of the change in taxable income.

***Preferred Stock Dividend***

The preferred stock dividend for the current and prioryear quarters was $0.9 million and $0.3 million, respectively.  The current year quarter amount represents afull three months.  The prior yearquarter is a smaller amount since it pertains to the period beginning September6, 2006, the date of the preferred stock issuance.

***Income from Discontinued Operations***

As discussed on our Form 10-K dated June 30, 2007, wehad sold our interest in the Rich Valley Properties during June 2007.  The prior year quarter results of operationsfor Rich Valley have been reclassified as discontinued operations and arepresented net of related income taxes.

 

17

----

***New Accounting Pronouncements***

On July 13, 2006, the FASB released FIN 48, “Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB Statement 109” (“FIN48”). FIN 48 requires companies to evaluate and disclose material uncertain taxpositions it has taken with various taxing jurisdictions.  Any interest and penalties related touncertain tax positions would be recorded as interest expense and general andadministrative expense, respectively.  Weadopted FIN 48 on July 1, 2007.  Atthe time of adoption and as of September 30, 2007, we determined the adoptionof FIN 48 does not materially affect our operating results, financial position,or future cash flows.  We are notinvolved in any examinations by the Internal Revenue Service.

 

SFAS No. 157, *FairValue Measurements*, (“SFAS No. 157”) was issued by theFinancial Accounting Standards Board (“FASB”) in September 2006. SFASNo. 157 defines fair value, establishes a framework for measuring fairvalue under GAAP and expands disclosures about fair value measurements. SFASNo. 57 applies to other accounting pronouncements that require or permitfair value measurement. No new requirements are included in SFAS No. 157,but application of the SFAS No. 157 will change current practice. SFASNo. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007. We do not expect adoption of SFASNo. 157 will have a material impact on our financial position, results ofoperations or cash flows.

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

See Notes 2 and 3 regarding the updates of our marketrisk for the quarter ended September 30, 2007.

**Item 4. Controls and Procedures.**

As of the end of the period covered by this report, weconducted an evaluation, under the supervision and with the participation ofour chief executive officer and chief financial officer of our disclosurecontrols and procedures as defined in Rule 13a-15(e) andRule 15d-15(e) of the Securities Exchange Act of 1934 (the “ExchangeAct”). Based upon this evaluation, our chief executive officer and chieffinancial officer concluded that our disclosure controls and procedures wereeffective to ensure that information required to be disclosed by us in the reportsthat we file or submit under the Exchange Act is: (1) accumulated andcommunicated to our management, including our chief executive officer and chieffinancial officer, as appropriate to allow timely decisions regarding requireddisclosure; and (2) recorded, processed, summarized and reported, withinthe time periods specified in the Securities and Exchange Commission’srules and forms.

During the quarter ended September 30, 2007, there wasno change in our internal control over financial reporting that has materiallyaffected or is reasonably likely to materially affect our internal control overfinancial reporting.

**PART II — OTHER INFORMATION**

**Item 1. Legal Proceedings.**

See Note 11 which is incorporated into this “Item 1.Legal Proceedings” by reference.

**Item 6. Exhibits.**
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                  |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1                 |       | Registration Rights  Agreement dated November 2, 2007 by and among Cano Petroleum, Inc. and the  Buyers listed therein, incorporated by reference from Exhibit 4.1 to the  Current Report on Form 8-K filed on November 6, 2007. |
| 10.1                |       | Form of Restricted  Stock Award Agreement (July 2007), incorporated by reference from Exhibit  10.1 to Current Report on Form 8-K filed on July 2, 2007.                                                                         |

 

18

----

| 10.2   |   | Form of Nonqualified  Stock Option Agreement (July 2007), incorporated by reference from Exhibit  10.2 to Current Report on Form 8-K filed on July 2, 2007.                                                                                                                                                                                                                                                                                                                                                      |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3   |   | Form of Amendment to  Restricted Stock Award Agreements (August 2007), incorporated by reference  from Exhibit 10.96 to Annual Report on Form 10-K for the year-ended June 30,  2007.                                                                                                                                                                                                                                                                                                                            |
| 10.4   |   | Form of Restricted  Stock Award Agreements (August 2007), incorporated by reference from Exhibit  10.97 to Annual Report on Form 10-K for the year-ended June 30, 2007.                                                                                                                                                                                                                                                                                                                                          |
| 10.5   |   | Amendment No. 6 dated  as of August 13, 2007 by and among Cano Petroleum, Inc., Square One Energy,  Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc.,  Pantwist, LLC, Cano Petro of New Mexico, Inc., W.O. Operating Company, Ltd.  and W.O. Production Company, Ltd., Union Bank of California, N.A., as  Administrative Agent, Issuing Lender and Lender and Natixis, incorporated by  reference from Exhibit 10.98 to Annual Report on Form 10-K for the year-ended  June 30, 2007. |
| 10.6   |   | First Amendment to the  Security Agreement dated as of July 9, 2007 by and among Cano Petroleum,  Inc., Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada,  Inc., WO Energy, Inc., Pantwist, LLC, Cano Petro of New Mexico, Inc., W.O.  Operating Company, Ltd. and W.O. Production Company, Ltd., and Union Bank of  California, N.A., as Senior Agent, incorporated by reference from Exhibit  10.99 to Annual Report on Form 10-K for the year-ended June 30, 2007.                      |
| 10.7   |   | First Amendment to the  Pledge Agreement dated as of July 9, 2007 by and among Cano Petroleum, Inc.,  W.O. Energy of Nevada, Inc. and WO Energy, Inc. and Union Bank of California,  N.A., as Senior Agent, incorporated by reference from Exhibit 10.100 to  Annual Report on Form 10-K for the year-ended June 30, 2007.                                                                                                                                                                                       |
| 10.8   |   | Amendment No. 7 dated  as of September 7, 2007 by and among Cano Petroleum, Inc., Square One Energy,  Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc.,  Pantwist, LLC, Cano Petro of New Mexico, Inc., W.O. Operating Company, Ltd.  and W.O. Production Company, Ltd., Union Bank of California, N.A., as  Administrative Agent, Issuing Lender and Lender and Natixis, incorporated by  reference from Exhibit 10.1 to Current Report on Form 8-K filed on September  11, 2007.     |
| 10.9   |   | Securities Purchase  Agreement dated November 2, 2007 by and among Cano Petroleum, Inc. and the  Buyers listed therein, incorporated by reference from Exhibit 10.1 to Current  Report on Form 8-K filed on November 6, 2007.                                                                                                                                                                                                                                                                                    |
| 10.10* |   | Sponsorship Agreement  dated December 16, 2004 by and between R.C. Boyd Enterprises, LLC  and Cano Petroleum, Inc.                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.11* |   | First Amendment dated  August 17, 2005 to Sponsorship Agreement by and between R.C. Boyd  Enterprises, LLC and Cano Petroleum, Inc.                                                                                                                                                                                                                                                                                                                                                                              |
| 10.12* |   | Second Amendment to  Sponsorship Agreement by and between R.C. Boyd Enterprises, LLC and Cano  Petroleum, Inc.                                                                                                                                                                                                                                                                                                                                                                                                   |
| 31.1*  |   | Certification by Chief  Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the  Exchange Act, promulgated pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                                                                                                                                                            |
| 31.2*  |   | Certification by Chief  Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the  Exchange Act, promulgated pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                                                                                                                                                            |
| 32.1*  |   | Certification by Chief  Executive Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the  Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States  Code, promulgated pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                       |
| 32.2*  |   | Certification by Chief  Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the  Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States  Code, promulgated pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                       |

----

*                    Filedherewith

 

19

----

**SIGNATURES**

In accordance with the requirements of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
| **CANO  PETROLEUM, INC.** |      |
|---------------------------|-----------|
|                      |      |
| Date: November 7, 2007    | By:  | /s/ S. Jeffrey Johnson |   |
|                      |      | S. Jeffrey Johnson |
|                      |      | Chief Executive Officer |
|                      |      |
|                      |      |
| Date: November 7, 2007    | By:  | /s/ Morris B. Smith |   |
|                      |      | Morris B. Smith |
|                      |      | Senior Vice-President  and Chief Financial Officer |
|                      |      |
|                      |      |
| Date: November 7, 2007    | By:  | /s/ Michael J. Ricketts |   |
|                      |      | Michael J. Ricketts |
|                      |      | Vice-President and  Principal Accounting Officer |

 

 

 

20

----