**EXHIBIT 10.7**

**NONQUALIFIED STOCK OPTION AGREEMENT**

**CANO PETROLEUM,INC.2005 LONG-TERM INCENTIVE PLAN**

1.             Grant of Option.  Pursuant to the Cano Petroleum, Inc. 2005Long-Term Incentive Plan (the “***Plan***”) for employees, consultants and outside directorsof Cano Petroleum, Inc., a Delaware corporation (the “***Company***”), theCompany grants to

William O. PowellIII(the “***Participant***”),

an option topurchase shares of Common Stock (“***Common Stock***”) of the Company as follows:

On the date hereof, theCompany grants to the Participant an option (the “***Option***” or “***Stock Option***”) topurchase Twenty Thousand One Hundred Thirty-Seven (20,137) full shares (the “***Optioned Shares***”) ofCommon Stock at an Option Price equal to $4.73 per share, being the closingprice of the Company’s Common Stock on April 4, 2007.  The Date of Grant of this Stock Option isApril 4, 2007.

The “***Option Period***” shallcommence on the Date of Grant and shall expire on the date immediatelypreceding the tenth (10th)anniversary of the Date of Grant.  The StockOption is a Nonqualified Stock Option. This Stock Option is intended to comply with the provisions governingnonqualified stock options under Internal Revenue Service Notice 2005-1 and theproposed Treasury Regulations issued under Section 409A of the Code onSeptember 29, 2005 in order to exempt this Stock Option from application ofSection 409A of the Code.

2.             Subject to Plan.  The Stock Option and its exercise are subjectto the terms and conditions of the Plan, and the terms of the Plan shall controlto the extent not otherwise inconsistent with the provisions of this Agreement.The capitalized terms used herein that are defined in the Plan shall have thesame meanings assigned to them in the Plan. The Stock Option is subject to any rules promulgated pursuant to thePlan by the Board or the Committee and communicated to the Participant inwriting.

3.             Vesting; Time of Exercise.  Except as specifically provided in thisAgreement and subject to certain restrictions and conditions set forth in thePlan, 100% of the total Optioned Shares shall vest and that portion of theStock Option shall become exercisable on December 28, 2007, provided theParticipant is employed by (or, if the Participant is a consultant or anOutside Director, is providing services to) the Company or a Subsidiary on thatdate.  In the event that a Change inControl occurs, then immediately prior to the effective date of such Change inControl the total Optioned Shares not previously vested shall thereuponimmediately become vested and this Option shall become fully exercisable if notpreviously so exercisable.

4.             Term; Forfeiture.

a.               Except asotherwise provided in this Agreement, to the extent the unexercised portion ofthe Stock Option relates to Optioned Shares which are not vested on the date ofthe Participant’s Termination of Service, the Stock Option will be terminatedon that date.  The unexercised portion ofthe Stock Option that relates to Optioned Shares which are vested willterminate at the first of the following to occur:

i.              5 p.m. on the date the Option Period terminates;

ii.             5 p.m. on the date which is twelve(12) months following the date of the Participant’s Termination of Service dueto death or Total and Permanent Disability;

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iii.            5 p.m. on the date of the Participant’sTermination of Service by the Company for cause (as defined herein);

iv.            5 p.m. on the date which is ninety(90) days following the date of the Participant’s Termination of Service forany reason not otherwise specified in this Section 4.a.; or

v.             5 p.m. on the date the Company causes any portion of theOption to be forfeited pursuant to Section 7 hereof.

b.             Solely for purposes of this Section 4, “***Cause***” shall mean (i) theParticipant’s gross negligence in the performance or intentional nonperformanceof any of his duties and responsibilities (which remains uncured and continuesfor thirty (30) days after delivery of written notice); (ii) the Participant’sdishonesty or fraud with respect to the business, reputation or affairs of theCompany; (iii) the Participant’s conviction of a felony or crime involvingmoral turpitude; (iv) the Participant’s debilitating drug or alcohol abuse asdetermined by a qualified physician; (v) the Participant’s material breach ofany provisions of an employment, consulting or service agreement between theCompany and the Participant; or (vi) the Participant’s material violation ofany written Company policy (which remains uncured or continues thirty (30) daysafter delivery of written notice).

5.             Who May Exercise.  Subject to the terms and conditions set forthin Sections 3 and 4 above, during the lifetime of the Participant, theStock Option may be exercised only by the Participant, or by the Participant’sguardian or personal or legal representative. If the Participant’s Termination of Service is due to his death prior tothe date specified in Section 4.i. hereof, or the Participant dies priorto the termination dates specified in Sections 4.i., ii., iii., or iv.hereof, and the Participant has not exercised the Stock Option as to themaximum number of vested Optioned Shares as set forth in Section 3hereof as of the date of death, the following persons may exercise theexercisable portion of the Stock Option on behalf of the Participant at anytime prior to the earliest of the dates specified in Section 4hereof:  the personal representative ofhis estate, or the person who acquired the right to exercise the Stock Optionby bequest or inheritance or by reason of the death of the Participant;provided that the Stock Option shall remain subject to the other terms of thisAgreement, the Plan, and applicable laws, rules, and regulations.  Notwithstanding the foregoing sentence, bydelivering to the Company the prescribed form (see Appendix A), the Participantmay designate one or more beneficiaries and successor beneficiaries who mayexercise the exercisable portion of the Option on behalf of the Participant atany time prior to the earliest of the dates specified in Section 4hereof (provided that the Option shall remain subject to the other terms ofthis Agreement and applicable laws, rules, and regulations) in the event (i) ofthe Participant’s Termination of Service due to his death prior to the datespecified in Section 4.a.i. hereof, or (ii) the Participant dies prior to the termination dates specified in Sections4.a.i., ii., iii., iv. or v. hereof, and the Participant has not exercisedthe Option as to the maximum number of vested Optioned Shares as set forth in Section 3hereof as of the date of death.  In theevent the Participant does not deliver to the Company a form designating one ormore beneficiaries, or no designated beneficiary survives the Participant, theforegoing sentence shall not apply.

6.             No Fractional Shares.  The Stock Option may be exercised only with respectto full shares, and no fractional share of stock shall be issued.

7.             Manner of Exercise.  Subject to such administrative regulations asthe Committee may from time to time adopt, the Stock Option may be exercised bythe delivery of written notice to the Committee setting forth the number ofshares of Common Stock with respect to which the Stock Option is to beexercised, the date of exercise thereof (the “***Exercise Date***”) which shall be at leastthree (3) days after giving such notice unless an earlier time shall have beenmutually agreed upon.  On the ExerciseDate, the Participant shall deliver to the Company consideration with a valueequal to the total Option Price of the shares to be purchased, payable as follows:  (a) cash, check, bank draft, or money orderpayable to the order of the Company, (b) Common Stock (including RestrictedStock owned by the Participant on the Exercise Date, valued at its Fair MarketValue on the Exercise Date, and which the Participant has not acquired from theCompany within six (6) months prior to the Exercise Date, (c) if the OptionedShares are Publicly Traded (as defined herein), by delivery (including by FAX)to the Company or its designated agent of an executed irrevocable optionexercise form together with irrevocable instructions from the Participant to abroker or dealer, reasonably acceptable to the Company, to sell certain of theshares of Common Stock purchased upon exercise of the Stock Option or to pledgesuch shares as collateral for a loan and promptly 

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deliver to theCompany the amount of sale or loan proceeds necessary to pay such purchaseprice, and/or (d) in any other form of valid consideration that is acceptableto the Committee in its sole discretion. In the event that shares ofRestricted Stock are tendered as consideration for the exercise of a StockOption, a number of shares of Common Stock issued upon the exercise of theStock Option equal to the number of shares of Restricted Stock used asconsideration therefor shall be subject to the same restrictions and provisionsas the Restricted Stock so tendered.  Forpurposes of this Section 7, the Common Stock shall be “***Publicly Traded***” ifthe Common Stock subjects the Company to the periodic reporting requirements ofSections 12(g) or 15(d) of the 1934 Act.

Uponpayment of all amounts due from the Participant, the Company shall causecertificates for the Optioned Shares then being purchased to be delivered tothe Participant (or the person exercising the Participant’s Stock Option in theevent of his death) at its principal business office within ten (10) businessdays after the Exercise Date. The obligation of the Company to deliver sharesof Common Stock shall, however, be subject to the condition that if at any timethe Company shall determine in its discretion that the listing, registration,or qualification of the Stock Option or the Optioned Shares upon any securitiesexchange or under any state or federal law, or the consent or approval of anygovernmental regulatory body, is necessary as a condition of, or in connectionwith, the Stock Option or the issuance or purchase of shares of Common Stockthereunder, then the Stock Option may not be exercised in whole or in partunless such listing, registration, qualification, consent, or approval shall havebeen effected or obtained free of any conditions not reasonably acceptable tothe Committee.

Ifthe Participant fails to pay for any of the Optioned Shares specified in suchnotice or fails to accept delivery thereof, then the Stock Option, and right topurchase such Optioned Shares may be forfeited by the Company.

8.             Nonassignability.  The Stock Option is not assignable ortransferable by the Participant except by will or by the laws of descent anddistribution.

9.             Rights as Stockholder.  The Participant will have no rights as astockholder with respect to any shares covered by the Stock Option until theissuance of a certificate or certificates to the Participant for the OptionedShares.  The Optioned Shares shall besubject to the terms and conditions of this Agreement regarding suchShares.  Except as otherwise provided in Section 10hereof, no adjustment shall be made for dividends or other rights for which therecord date is prior to the issuance of such certificate or certificates.

10.           Adjustment of Number of OptionedShares and Related Matters.  Thenumber of shares of Common Stock covered by the Stock Option, and the OptionPrices thereof, shall be subject to adjustment in accordance with Articles11 - 13 of the Plan.

11.           Nonqualified Stock Option.  The Stock Option shall not be treated as anIncentive Stock Option.

12.           Voting.  The Participant, as record holder of some orall of the Optioned Shares following exercise of this Stock Option, has theexclusive right to vote, or consent with respect to, such Optioned Shares untilsuch time as the Optioned Shares are transferred in accordance with thisAgreement or a proxy is granted pursuant to Section 13 below; provided,however, that this Section shall not create any voting right where theholders of such Optioned Shares otherwise have no such right.

13.           Proxies.  The Participant shall execute an irrevocableproxy with respect to any shares of Restricted Stock authorizing the Board tovote such shares on all issues until the expiration of the RestrictionPeriod.  Subject to the foregoingprovisions of this Section, the Participant may not grant a proxy to anyperson, other than a revocable proxy not to exceed 30 days in duration grantedto another stockholder for the sole purpose of voting for directors of theCompany.

14.           CommunityProperty.  Each spouse individuallyis bound by, and such spouse’s interest, if any, in any Optioned Shares issubject to, the terms of this Agreement. Nothing in this Agreement shall create a community property interest wherenone otherwise exists.

15.           Participant’s Representations.  Notwithstanding any of the provisions hereof,the Participant hereby agrees that he will not exercise the Stock Optiongranted hereby, and that the Company will not be obligated 

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to issue any sharesto the Participant hereunder, if the exercise thereof or the issuance of suchshares shall constitute a violation by the Participant or the Company of anyprovision of any law or regulation of any governmental authority.  Any determination in this connection by theCompany shall be final, binding, and conclusive.  The obligations of the Company and the rightsof the Participant are subject to all applicable laws, rules, and regulations.

16.           Investment Representation.  Unless the Common Stock is issued to him in atransaction registered under applicable federal and state securities laws, byhis execution hereof, the Participant represents and warrants to the Companythat all Common Stock which may be purchased hereunder will be acquired by theParticipant for investment purposes for his own account and not with any intentfor resale or distribution in violation of federal or state securitieslaws.  Unless the Common Stock is issuedto him in a transaction registered under the applicable federal and statesecurities laws, all certificates issued with respect to the Common Stock shallbear an appropriate restrictive investment legend and shall be heldindefinitely, unless they are subsequently registered under the applicablefederal and state securities laws or the Participant obtains an opinion ofcounsel, in form and substance satisfactory to the Company and its counsel,that such registration is not required.

17.           Participant’s Acknowledgments.  The Participant acknowledges receipt of acopy of the Plan, which is annexed hereto, and represents that he or she isfamiliar with the terms and provisions thereof, and hereby accepts this Optionsubject to all the terms and provisions thereof. The Participant hereby agreesto accept as binding, conclusive, and final all decisions or interpretations ofthe Committee or the Board, as appropriate, upon any questions arising underthe Plan or this Agreement.

18.           Law Governing.  This Agreement shall be governed by,construed, and enforced in accordance with the laws of the State of Texas(excluding any conflict of laws rule or principle of Texas law that might referthe governance, construction, or interpretation of this agreement to the lawsof another state).

19.           No Right to Continue Service orEmployment.  Nothing herein shall beconstrued to confer upon the Participant the right to continue in the employ orto provide services to the Company or any Subsidiary, whether as an employee oras a consultant or as an Outside Director, or interfere with or restrict in anyway the right of the Company or any Subsidiary to discharge the Participant asan employee, consultant or Outside Director at any time.

20.           Legal Construction.  In the event that any one or more of theterms, provisions, or agreements that are contained in this Agreement shall beheld by a Court of competent jurisdiction to be invalid, illegal, orunenforceable in any respect for any reason, the invalid, illegal, orunenforceable term, provision, or agreement shall not affect any other term,provision, or agreement that is contained in this Agreement and this Agreementshall be construed in all respects as if the invalid, illegal, or unenforceableterm, provision, or agreement had never been contained herein.

21.           Covenants and Agreements asIndependent Agreements. Each of the covenants and agreements that is setforth in this Agreement shall be construed as a covenant and agreementindependent of any other provision of this Agreement.  The existence of any claim or cause of actionof the Participant against the Company, whether predicated on this Agreement orotherwise, shall not constitute a defense to the enforcement by the Company ofthe covenants and agreements that are set forth in this Agreement.

22.           Entire Agreement.  This Agreement together with the Plan supersedeany and all other prior understandings and agreements, either oral or inwriting, between the parties with respect to the subject matter hereof andconstitute the sole and only agreements between the parties with respect to thesaid subject matter.  All priornegotiations and agreements between the parties with respect to the subjectmatter hereof are merged into this Agreement. Each party to this Agreement acknowledges that no representations,inducements, promises, or agreements, orally or otherwise, have been made byany party or by anyone acting on behalf of any party, which are not embodied inthis Agreement or the Plan and that any agreement, statement or promise that isnot contained in this Agreement or the Plan shall not be valid or binding or ofany force or effect.

23.           Parties Bound.  The terms, provisions, and agreements thatare contained in this Agreement shall apply to, be binding upon, and inure tothe benefit of the parties and their respective heirs, executors,administrators, legal representatives, and permitted successors and assigns,subject to the limitation on assignment expressly set forth herein. No person or entity shall be permitted toacquire any Optioned Shares without first executing and 

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delivering an agreement in the form satisfactory to the Company makingsuch person or entity subject to the restrictions on transfer contained herein.

24.           Modification.  No change or modification of this Agreementshall be valid or binding upon the parties unless the change or modification isin writing and signed by the parties; provided, however, that the Company maychange or modify this Agreement without Individual’s consent or signature ifthe Company determines, in its sole discretion, that such change ormodification is necessary for purposes of compliance with or exemption from therequirements of Section 409A of the Code or any regulations or other guidanceissued thereunder.

25.           Headings.  The headings that are used in this Agreementare used for reference and convenience purposes only and do not constitutesubstantive matters to be considered in construing the terms and provisions ofthis Agreement.

26.           Gender and Number.  Words of any gender used in this Agreementshall be held and construed to include any other gender, and words in thesingular number shall be held to include the plural, and vice versa, unless thecontext requires otherwise.

27.           Notice.  Any notice required or permitted to bedelivered hereunder shall be deemed to be delivered only when actually receivedby the Company or by the Participant, as the case may be, at the addresses setforth below, or at such other addresses as they have theretofore specified bywritten notice delivered in accordance herewith:

a.             Noticeto the Company shall be addressed and delivered as follows:

CanoPetroleum, Inc.801 Cherry Street, Unit 25, Suite 3200Fort Worth, TX  76102Attn:  Corporate Secretary

b.             Notice to the Participant shall be addressed anddelivered as set forth on the signature page.

28.           Tax Requirements.  The Participant is hereby advised to consultimmediately with his or her own tax advisor regarding the tax consequences ofthis Agreement.  The Company or, ifapplicable, any Subsidiary (for purposes of this Section 28, the term “***Company***” shall bedeemed to include any applicable Subsidiary), shall have the right to deductfrom all amounts hereunder paid in cash or other form, any Federal, state,local, or other taxes required by law to be withheld in connection with thisAward.  The Company may, in its solediscretion, also require the Participant receiving shares of Common Stockissued under the Plan to pay the Company the amount of any taxes that theCompany is required to withhold in connection with the Participant’s incomearising with respect to this Award.  Suchpayments shall be required to be made when requested by the Company and may berequired to be made prior to the delivery of any certificate representingshares of Common Stock.  Such payment maybe made (i) by the delivery of cash to the Company in an amount that equals orexceeds (to avoid the issuance of fractional shares under (iii) below) therequired tax withholding obligations of the Company; (ii) if the Company, inits sole discretion, so consents in writing, the actual delivery by theexercising Participant to the Company of shares of Common Stock other than (A)Restricted Stock, or (B)****Common Stock that the Participant has not acquired from theCompany within six (6) months prior to the date of exercise, which shares sodelivered have an aggregate Fair Market Value that equals or exceeds (to avoidthe issuance of fractional shares under (iii) below) the required taxwithholding payment; (iii) if the Company, in its sole discretion, so consentsin writing, the Company’s withholding of a number of shares to be deliveredupon the exercise of the Stock Option other than shares that will constituteRestricted Stock, which shares so withheld have an aggregate fair market valuethat equals (but does not exceed) the required tax withholding payment; or (iv)any combination of (i), (ii), or (iii). The Company may, in its sole discretion, withhold any such taxes fromany other cash remuneration otherwise paid by the Company to the Participant.

* * * * * * * *

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INWITNESS WHEREOF, the Company has caused this Agreement to be executed by itsduly authorized officer, and the Participant, to evidence his consent andapproval of all the terms hereof, has duly executed this Agreement, as of thedate specified in Section 1 hereof.
| ** ** | **COMPANY:**             |
|------------|--------------------------|
| ** ** | ** **               |
| ** ** | **CANO PETROLEUM, INC.** |
| ** ** | ** **               |
| ** ** | ** **               |
|       | By:                      |  /s/ S.  Jeffrey Johnson |
|       | Name:                    | S. Jeffrey Johnson |
|       | Title:                   | Chairman and Chief Executive Officer |
|       |                     |
|       |                     |
| ** ** | **PARTICIPANT:**         |
| ** ** | ** **               |
| ** ** | ** **               |
|       | William O. Powell III    |
|       | Signature                |
|       |                     |
|       | Name:                    | /s/ William O. Powell |
|       | Address:                 | 1505 Waterside Drive  League City, Texas 77573 |
|            |                          |  |  |  |  |

 

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**APPENDIXA**

**BeneficiaryDesignation**

To:                              CorporateSecretary designated in the Cano Petroleum Inc. Nonqualified Stock OptionAgreement by and between Cano Petroleum Inc. and William O. Powell III (the “Agreement”)

From:      William O. Powell III

Pursuantto Section 5 of the Agreement made as of April 4, 2007, I hereby designate thefollowing persons(s) as beneficiary(ies) who on my death who may exercise theexercisable portion of the Option on my behalf pursuant to the Agreement:

| Primary Beneficiary Name:    |   |   |
|------------------------------|--------|--------|
|                         |
| Secondary  Beneficiary Name: |   |   |

 

Inmaking the above designation, I reserve the right to revoke this beneficiarydesignation or change the beneficiary(ies) designated at any time or times andwithout the consent of any beneficiary.

Thisbeneficiary designation cancels and supersedes any beneficiary designation Ipreviously made with respect to this Agreement.

| Signed:    |   |
|------------|--------|
|       |   |
|       |   |
| Individual |   |
|       |   |
|       |   |
| Date       |   |

 

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