** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| ** ** | **(Mark One)**                                                                                          |
|------------|---------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                              |
| **x**      | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** ** | ** **                                                                                              |
|       | **For the quarterly period ended  September 30, 2008**                                             |
| ** ** | ** **                                                                                              |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom                  to                  **

 

**Commission file number 001-32496**

 

**CANO PETROLEUM, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**The Burnett Plaza**

**801 Cherry Street, Suite 3200**

**Fort Worth, TX 76102**

(Address of principal executive offices including zip code)

** **

**(817) 698-0900**

(Registrant’s telephone number including area code)

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the past 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes  x    No  o

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, a non-accelerated filer, or a smaller reporting company. See thedefinitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (check one):

 
| Large accelerated filer o |   | Accelerated filer x |   | Non-accelerated filer o | Smaller reporting company o |
|---------------------------|--------|---------------------|--------|-------------------------|-----------------------------|

 

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

 

State thenumber of shares outstanding of each of the issuer’s classes of common equity,as of the latest practicable date:  46,078,518 shares of common stock,$.0001 par value per share, as of November 6, 2008.

 

 

 

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**PART I — FINANCIAL INFORMATION**

 

**Item 1. Financial Statements.**

 

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

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                         | ** ** | **Pro Forma**     | ** **  | ** **             | ** ** | ** **        | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                                                         | ** ** | **September 30,** | ** **  | **September 30,** | ** ** | **June 30,** | ** ** |
| **In Thousands, Except  Shares and Per Share Amounts**                                                                                                                                                                                                                                             | ** ** | **2008**               | ** **  | **2008**               | ** ** | **2008**          | ** ** |
| *** ***                                                                                                                                                                                                                                                                                       | ** ** | **(Note 2)**           | ** **  | ** **             | ** ** | ** **        | ** ** |
| ***ASSETS***                                                                                                                                                                                                                                                                                       |       |                   | ** **  | ** **             | ** ** | ** **        | ** ** |
| **Current assets**                                                                                                                                                                                                                                                                                 |       |                   | ** **  | ** **             | ** ** | ** **        | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                                          |       | $                      | 6,757       |                   | $          | 11,455            |       | $ | 771 |   |
| Accounts receivable                                                                                                                                                                                                                                                                                |       | 3,309                  |        | 3,309                  |       | 3,929             |       |
| Deferred tax asset                                                                                                                                                                                                                                                                                 |       | —                 |        | —                 |       | 3,592             |       |
| Derivative assets                                                                                                                                                                                                                                                                                  |       | 893                    |        | 893                    |       | —            |       |
| Inventory and other current assets                                                                                                                                                                                                                                                                 |       | 1,355                  |        | 1,355                  |       | 646               |       |
| Assets held for sale (Note 2)                                                                                                                                                                                                                                                                      |       | —                 |        | 22,236                 |       | 22,097            |       |
| Total current assets                                                                                                                                                                                                                                                                               |       | 12,314                 |        | 39,248                 |       | 31,035            |       |
|                                                                                                                                                                                                                                                                                               |       |                   |        |                   |       |              |       |
| **Oil and gas properties****,**successful  efforts method                                                                                                                                                                                                                                          |       | 269,064                |        | 269,064                |       | 251,750           |       |
| Less accumulated depletion and depreciation                                                                                                                                                                                                                                                        |       | (9,117                 | )           | (9,117                 | )          | (7,984            | )          |
| Net oil and gas properties                                                                                                                                                                                                                                                                         |       | 259,947                |        | 259,947                |       | 243,766           |       |
|                                                                                                                                                                                                                                                                                               |       |                   |        |                   |       |              |       |
| Fixed assets and other, net                                                                                                                                                                                                                                                                        |       | 2,079                  |        | 2,079                  |       | 2,096             |       |
| Derivative assets                                                                                                                                                                                                                                                                                  |       | 642                    |        | 642                    |       | 125               |       |
| Goodwill                                                                                                                                                                                                                                                                                           |       | 786                    |        | 786                    |       | 786               |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                                   | ** ** | **$**                  | **275,768** | ** **             | **$**      | **302,702**       | ** ** | **$** | **277,808** | ** ** |
|                                                                                                                                                                                                                                                                                               |       |                   |        |                   |       |              |       |
| ***LIABILITIES,  TEMPORARY EQUITY AND STOCKHOLDERS’ EQUITY***                                                                                                                                                                                                                                 |       |                   |        |                   |       |              |       |
| **Current liabilities**                                                                                                                                                                                                                                                                            |       |                   |        |                   |       |              |       |
| Accounts payable                                                                                                                                                                                                                                                                                   |       | $                      | 13,215      |                   | $          | 13,215            |       | $ | 8,696 |   |
| Accrued liabilities                                                                                                                                                                                                                                                                                |       | 2,797                  |        | 2,797                  |       | 2,840             |       |
| Deferred litigation credit (Note 12)                                                                                                                                                                                                                                                               |       | 6,000                  |        | 6,000                  |       | —            |       |
| Deposit related to sale of discontinued operations  (Note 2)                                                                                                                                                                                                                                       |       | —                 |        | 2,135                  |       | —            |       |
| Liabilities associated with discontinued  operations (Note 2)                                                                                                                                                                                                                                      |       | —                 |        | 1,528                  |       | 1,278             |       |
| Oil and gas sales payable                                                                                                                                                                                                                                                                          |       | 697                    |        | 697                    |       | 815               |       |
| Derivative liabilities                                                                                                                                                                                                                                                                             |       | 912                    |        | 912                    |       | 9,978             |       |
| Current portion of asset retirement obligations                                                                                                                                                                                                                                                    |       | 328                    |        | 328                    |       | 345               |       |
| Total current liabilities                                                                                                                                                                                                                                                                          |       | 23,949                 |        | 27,612                 |       | 23,952            |       |
| **Long-term liabilities**                                                                                                                                                                                                                                                                          |       |                   |        |                   |       |              |       |
| Long-term debt (Note 4)                                                                                                                                                                                                                                                                            |       | —                 |        | 42,700                 |       | 73,500            |       |
| Asset retirement obligations                                                                                                                                                                                                                                                                       |       | 3,038                  |        | 3,038                  |       | 2,968             |       |
| Deferred litigation credit (Note 12)                                                                                                                                                                                                                                                               |       | —                 |        | —                 |       | 6,000             |       |
| Derivative liabilities                                                                                                                                                                                                                                                                             |       | 2,775                  |        | 2,775                  |       | 16,390            |       |
| Deferred tax liabilities                                                                                                                                                                                                                                                                           |       | 37,702                 |        | 30,599                 |       | 26,062            |       |
| Total liabilities                                                                                                                                                                                                                                                                                  |       | 67,464                 |        | 106,724                |       | 148,872           |       |
|                                                                                                                                                                                                                                                                                               |       |                   |        |                   |       |              |       |
| **Temporary equity**                                                                                                                                                                                                                                                                               |       |                   |        |                   |       |              |       |
| Series D convertible preferred stock and  paid-in-kind dividend; par value $.0001 per share, stated value $1,000 per  share; 49,116 shares authorized; 44,474 shares issued; liquidation preference  at September 30, 2008 and June 30, 2008 of $48,886 and $48,353,  respectively. |       | 45,619                 |        | 45,619                 |       | 45,086            |       |
|                                                                                                                                                                                                                                                                                               |       |                   |        |                   |       |              |       |
| **Commitments and contingencies  (Note 12)**                                                                                                                                                                                                                                                       |       |                   |        |                   |       |              |       |
| **Stockholders’ equity**                                                                                                                                                                                                                                                                      |       |                   |        |                   |       |              |       |
| Common stock, par value $.0001 per share;  100,000,000 authorized; 47,346,812 and 46,078,518 shares issued and  outstanding at September 30, 2008, respectively; and 40,523,168 and  39,254,874 shares issued and outstanding at June 30, 2008, respectively.                            |       | 5                      |        | 5                      |       | 4                 |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                         |       | 176,521                |        | 176,521                |       | 121,831           |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                |       | (13,270                | )           | (25,596                | )          | (37,414           | )          |
| Treasury stock, at cost; 1,268,294 shares held in  escrow                                                                                                                                                                                                                                          |       | (571                   | )           | (571                   | )          | (571              | )          |
| Total stockholders’ equity                                                                                                                                                                                                                                                                    |       | 162,685                |        | 150,359                |       | 83,850            |       |
| **TOTAL LIABILITIES, TEMPORARY  EQUITY AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                             | ** ** | **$**                  | **275,768** | ** **             | **$**      | **302,702**       | ** ** | **$** | **277,808** | ** ** |

 

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

 

2

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**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                                                         | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **In Thousands, Except  Per Share Data**                                                                           | ** ** | **Pro Forma**                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                                         | ** ** | **(Note 2)**                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Operating Revenues:**                                                                                            | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Crude oil sales                                                                                                    |       | $                                                        | 8,133      |   | $ | 8,133 |   | $ | 4,057 |   |
| Natural gas sales                                                                                                  |       | 2,734                                                    |       | 2,734 |   | 2,451 |   |
| Other revenue                                                                                                      |       | 79                                                       |       | 79 |   | 79 |   |
| Total operating revenues                                                                                           |       | 10,946                                                   |       | 10,946 |   | 6,587 |   |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Operating Expenses:**                                                                                            |       |                                                     |       |   |   |   |   |
| Lease operating                                                                                                    |       | 5,102                                                    |       | 5,102 |   | 2,573 |   |
| Production and ad valorem taxes                                                                                    |       | 1,053                                                    |       | 1,053 |   | 494 |   |
| General and administrative                                                                                         |       | 4,860                                                    |       | 4,860 |   | 3,622 |   |
| Impairment of long-lived assets (Note 11)                                                                          |       | 3,516                                                    |       | 3,516 |   | — |   |
| Depletion and depreciation                                                                                         |       | 1,219                                                    |       | 1,219 |   | 862 |   |
| Accretion of discount on asset retirement  obligations                                                             |       | 77                                                       |       | 77 |   | 52 |   |
| Total operating expenses                                                                                           |       | 15,827                                                   |       | 15,827 |   | 7,603 |   |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Loss from operations**                                                                                           |       | (4,881                                                   | )          | (4,881 | ) | (1,016 | ) |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Other income (expense):**                                                                                        |       |                                                     |       |   |   |   |   |
| Interest expense and other                                                                                         |       | (124                                                     | )          | (124 | ) | (200 | ) |
| Unrealized gain (loss) on commodity derivatives                                                                    |       | 24,247                                                   |       | 24,247 |   | (516 | ) |
| Realized gain (loss) on commodity derivatives                                                                      |       | (552                                                     | )          | (552 | ) | 296 |   |
| Total other income (expense)                                                                                       |       | 23,571                                                   |       | 23,571 |   | (420 | ) |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| Income (loss) from continuing operations before  income taxes                                                      |       | 18,690                                                   |       | 18,690 |   | (1,436 | ) |
| Deferred income tax benefit (expense)                                                                              |       | (7,327                                                   | )          | (7,327 | ) | 500 |   |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| Income (loss) from continuing operations                                                                           |       | 11,363                                                   |       | 11,363 |   | (936 | ) |
| Income from discontinued operations, net of  related taxes of $7,904 for pro forma, $801 in 2008 and $370 in 2007. |       | 13,717                                                   |       | 1,391 |   | 658 |   |
| **Net income (loss)**                                                                                              |       | 25,080                                                   |       | 12,754 |   | (278 | ) |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| Preferred stock dividend                                                                                           |       | 936                                                      |       | 936 |   | 967 |   |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Net income (loss) applicable to  common stock**                                                                  |       | $                                                        | 24,144     |   | $ | 11,818 |   | $ | (1,245 | ) |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Net income (loss) per share -  basic**                                                                           |       |                                                     |       |   |   |   |   |
| Continuing operations                                                                                              |       | $                                                        | 0.23       |   | $ | 0.23 |   | $ | (0.06 | ) |
| Discontinued operations                                                                                            |       | 0.30                                                     |       | 0.03 |   | 0.02 |   |
| **Net income (loss) per share -  basic**                                                                           |       | $                                                        | 0.53       |   | $ | 0.26 |   | $ | (0.04 | ) |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Net income (loss) per share -  diluted**                                                                         |       |                                                     |       |   |   |   |   |
| Continuing operations                                                                                              |       | $                                                        | 0.21       |   | $ | 0.21 |   | $ | (0.06 | ) |
| Discontinued operations                                                                                            |       | 0.25                                                     |       | 0.02 |   | 0.02 |   |
| **Net income (loss) per share -  diluted**                                                                         |       | $                                                        | 0.46       |   | $ | 0.23 |   | $ | (0.04 | ) |
|                                                                                                               |       |                                                     |       |   |   |   |   |
| **Weighted average common shares  outstanding**                                                                    |       |                                                     |       |   |   |   |   |
| Basic                                                                                                              |       | 45,338                                                   |       | 45,338 |   | 32,616 |   |
| Diluted                                                                                                            |       | 54,504                                                   |       | 54,504 |   | 32,616 |   |

 

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

 

3

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**CANO PETROLEUM, INC.CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITYJULY 1, 2008 THROUGH SEPTEMBER 30, 2008(Unaudited)**

 
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **  |
|-------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------|------------|-------------------------|------------|------------|-------------|
| **Dollar Amounts in  Thousands**                                  | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**     | ** ** | **Deficit**             | ** ** | **Shares** | ** **  | **Amount** | ** ** | **Total** | ** ** |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| **Balance at June 30, 2008**                                 | ** ** | **40,523,168**        | ** ** | **$**                   | **4**      | ** **      | **$**      | **121,831**             | ** ** | **$**      | **(37,414** | **)** | **1,268,294** | ** ** | **$** | **(571** | **)** | **$** | **83,850** | ** ** |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| Net proceeds from issuance of common shares on  July 1, 2008 |       | 7,000,000             |       | 1                       |       | 53,907          |       | —                  |       | —     |        | — |   | 53,908 |   |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| Forfeiture of restricted stock                                    |       | (176,356              | )          | —                  |       | (175            | )          | —                  |       | —     |        | — |   | (175 | ) |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| Stock-based compensation                                          |       | —                |       | —                  |       | 958             |       | —                  |       | —     |        | — |   | 958 |   |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| Preferred stock dividend                                          |       | —                |       | —                  |       | —          |       | (936                    | )          | —     |        | — |   | (936 | ) |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| Net income                                                        |       | —                |       | —                  |       | —          |       | 12,754                  |       | —     |        | — |   | 12,754 |   |
|                                                              |       |                  |       |                    |       |            |       |                    |       |       |        |   |   |   |   |
| **Balance at September 30,  2008**                           | ** ** | **47,346,812**        | ** ** | **$**                   | **5**      | ** **      | **$**      | **176,521**             | ** ** | **$**      | **(25,596** | **)** | **1,268,294** | ** ** | **$** | **(571** | **)** | **$** | **150,359** | ** ** |

 

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

 

4

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**CANO PETROLEUM, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
| ** **                                                                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                  | ** ** | **September 30,**           | ** ** |
| **In Thousands**                                                                       | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **Cash flow from operating activities:**                                |       |                             |       |   |   |
| Net income (loss)                                                                           |       | $                                | 12,754     |   | $ | (278 | ) |
| Adjustments needed to reconcile net income (loss)  to net cash flow provided by operations: |       |                             |       |   |   |
| Unrealized loss (gain) on commodity derivatives                                             |       | (24,247                          | )          | 516 |   |
| Accretion of discount on asset retirement  obligations                                      |       | 77                               |       | 52 |   |
| Depletion and depreciation                                                                  |       | 1,219                            |       | 862 |   |
| Impairment of long-lived assets                                                             |       | 3,516                            |       | — |   |
| Stock based compensation expense                                                            |       | 958                              |       | 583 |   |
| Deferred income tax expense (benefit)                                                       |       | 8,128                            |       | (143 | ) |
| Income from discontinued operations                                                         |       | —                           |       | 275 |   |
| Amortization of debt issuance and prepaid expenses                                          |       | 362                              |       | 309 |   |
|                                                                                        |       |                             |       |   |   |
| Changes in assets and liabilities relating to  operations:                                  |       |                             |       |   |   |
| Accounts receivable                                                                         |       | 562                              |       | 519 |   |
| Inventory and other current assets                                                          |       | (956                             | )          | (751 | ) |
| Accounts payable                                                                            |       | (107                             | )          | (843 | ) |
| Accrued liabilities                                                                         |       | 483                              |       | (229 | ) |
| Oil and gas sales payable                                                                   |       | (234                             | )          | 182 |   |
| Derivative liability                                                                        |       | 144                              |       | — |   |
| **Net cash provided by operations**                                                         | ** ** | **2,659**                        | ** ** | **1,054** | ** ** |
|                                                                                        |       |                             |       |   |   |
| **Cash flow from investing  activities:**                                                   |       |                             |       |   |   |
| Additions to oil and gas properties, fixed assets  and other                                |       | (16,510                          | )          | (17,678 | ) |
| Deposit related to sale of discontinued operations                                          |       | 2,135                            |       | — |   |
| **Net cash used in investing  activities**                                                  | ** ** | **(14,375**                      | **)**      | **(17,678** | **)** |
|                                                                                        |       |                             |       |   |   |
| **Cash flow from financing  activities:**                                                   |       |                             |       |   |   |
| Paydown of long-term debt                                                                   |       | (54,500                          | )          | 15,500 |   |
| Borrowings of long-term debt                                                                |       | 23,700                           |       | — |   |
| Payments for debt issuance costs                                                            |       | (305                             | )          | (80 | ) |
| Proceeds from issuance of common stock, net                                                 |       | 53,908                           |       | 103 |   |
| Payment of preferred stock dividend                                                         |       | (403                             | )          | (434 | ) |
| **Net cash from financing  activities**                                                     | ** ** | **22,400**                       | ** ** | **15,089** | ** ** |
|                                                                                        |       |                             |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                       |       | 10,684                           |       | (1,535 | ) |
| Cash and cash equivalents at beginning of period                                            |       | 771                              |       | 2,119 |   |
| **Cash and cash equivalents at  end of period**                                             | ** ** | **$**                            | **11,455** | ** ** | **$** | **584** | ** ** |
|                                                                                        |       |                             |       |   |   |
| **Supplemental disclosure of  noncash transactions:**                                       |       |                             |       |   |   |
| Payments of preferred stock dividend in kind                                                |       | $                                | 533        |   | $ | 533 |   |
|                                                                                        |       |                             |       |   |   |
| **Supplemental disclosure of cash  transactions:**                                          |       |                             |       |   |   |
| Cash paid during the period for interest                                                    |       | $                                | 605        |   | $ | 399 |   |

 

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

 

5

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**CANOPETROLEUM, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

 

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

 

The interim consolidatedfinancial statements of Cano Petroleum, Inc. are unaudited and contain alladjustments (consisting primarily of normal recurring accruals) necessary for afair statement of the results for the interim periods presented. Results forinterim periods are not necessarily indicative of results to be expected for afull year due in part, but not limited to, the volatility in prices for crudeoil and natural gas, future commodity prices for commodity derivatives,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 these consolidated interim financial statements in conjunctionwith the audited consolidated financial statements and notes thereto includedin our Form 10-K for the year ended June 30, 2008.

 

The accompanyingfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) andinclude the accounts of Cano and its wholly-owned subsidiaries. Intercompanyaccounts and transactions are eliminated. In preparing the accompanyingfinancial statements, management has made certain estimates and assumptionsthat affect reported amounts in the financial statements and disclosures ofcontingencies. Actual results may differ from those estimates. Significantassumptions are required in the valuation of proved oil and natural gasreserves, which may affect the amount at which oil and natural gas propertiesare recorded. The computation of stock based compensation expense requiresassumptions such as volatility, expected life and the risk-free interest rate.It is at least reasonably possible these estimates could be revised in the nearterm, and these revisions could be material.

 

***ProForma Financial Information***

 

We have presentedunaudited pro forma financial information on our consolidated balance sheetsand consolidated statements of operations, as of and for the three months endedSeptember 30, 2008, to present the effects of the sale of Pantwist, LLCfor  $40.1 million, ($42.7 million including$2.0 million of cash received from discontinued operating income and $0.6million of broker fees) which was completed on October 1, 2008.  The pro forma consolidated balance sheet asof September 30, 2008 reflects the sale as if it had occurred on September 30,2008.  The pro forma consolidatedstatement of operations for the three months ended September 30, 2008reflects the sale as if it had occurred on July 1, 2008.  This is further discussed under Note 2.

 

***NewAccounting Pronouncements***

 

In February 2007, theFASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities*—*Including an amendment of FASB Statement No. 115*(“SFAS No. 159”). SFAS No. 159 permits entities to choose to measuremany financial instruments and certain other items at fair value that are notcurrently required to be measured at fair value. It provides entities with theopportunity to mitigate volatility in reported earnings caused by measuringrelated assets and liabilities differently without having to apply complexhedge accounting provisions. We have adopted SFAS No. 159 on July 1,2008. The adoption of SFAS No. 159 did not have a material impact on ourfinancial position, results of operations or cash flows.

 

In December 2007, theFASB issued SFAS No. 141 (revised 2007), *BusinessCombinations* (“SFAS No. 141R”). Among other things, SFAS No. 141Restablishes principles and requirements for how the acquirer in a businesscombination (i) recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquired business, (ii) recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase, and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS No. 141R is effective for fiscal yearsbeginning on or after December 15, 2008, with early adoption prohibited.This standard will change our accounting treatment for business combinations ona prospective basis.

 

6

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In December 2007, theFASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements, an Amendment of ARB No. 51*(“SFAS No. 160”). SFAS No. 160 establishes accounting and reportingstandards for noncontrolling interests in a subsidiary and for the deconsolidationof a subsidiary. Minority interests will be recharacterized as noncontrollinginterests and classified as a component of equity. It also establishes a singlemethod of accounting for changes in a parent’s ownership interest in asubsidiary and requires expanded disclosures. This statement is effective forfiscal years beginning on or after December 15, 2008, with early adoptionprohibited. We will adopt SFAS No. 161 on July 1, 2009. We do notexpect the adoption of this statement will have a material impact on ourfinancial position, results of operations or cash flows.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities—An Amendment of FASB Statement133* (“SFAS No. 161”). SFAS No. 161 amends and expands SFASNo. 133 to enhance required disclosures regarding derivatives and hedgingactivities. It requires companies to provide additional disclosure to discussthe uses of derivative instruments; the accounting for derivative instrumentsand related hedged items under SFAS No. 133; and how derivativeinstruments and related hedged items affect the company’s financial position,financial performance and cash flows. We will adopt SFAS No. 161 on July 1,2009. We do not expect the adoption of this statement will have a materialimpact on our financial position, results of operations or cash flows.

 

 **2.   DISCONTINUED OPERATIONS**

 

On October 1, 2008,we sold our wholly-owned subsidiary, Pantwist, LLC, for $40.1 million ($42.7million including $2.0 million of cash received from discontinued operatingincome and $0.6 million of broker fees). The sale had an effective date of July 1, 2008.  There arecertain post-closing adjustments that are to be finalized between the partieswithin 90 days of October 1, 2008.  We do not anticipate thatpost-closing adjustments will be material in amount.  We anticipaterecording a pre-tax gain on the sale of approximately $19.4 million ($12.3million after-tax), and any current tax liabilities relating to such gain willbe fully offset by existing net operating losses. We used the entire $42.7million net cash proceeds received from the transaction and cash on hand to paydown amounts outstanding under the senior credit agreement on October 1,2008 (as discussed in Note 4).

 

On September 8,2008, the buyer paid a $2.1 million deposit toward the purchase of Pantwist,LLC which was included within the $40.1 million purchase on the October 1,2008 closing date.  Between July 1,2008 (effective date of the sale) and September 30, 2008, the netoperating income from Pantwist operations amounted to $2.2 million pre-tax($1.4 million after-tax).

 

At September 30 andJune 30, 2008, the assets of Pantwist, LLC are classified as assets heldfor sale and the liabilities are classified as liabilities associated withdiscontinued operations on the consolidated balance sheets.  At September 30, 2008 and June 30,2008, the reclassified net book value of $20.7 million and $20.8 million,respectively, primarily represents the oil and gas properties (net) and isshown at its carrying amount, which is lower than the fair value at September 30,2008.  The operating results of Pantwist,LLC for the three months ended September 30, 2008 and 2007 have beenreclassified as discontinued operations in the consolidated statements ofoperations as detailed in the table below.

 

7

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| ** **                                             | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **September 30,**           | ** ** |
| ** **                                             | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **Operating Revenues:**                                |       |                             |       |   |   |
| Crude oil sales                                        |       | $                                | 1,296      |   | $ | 939 |   |
| Natural gas sales                                      |       | 1,696                            |       | 1,195 |   |
| Total operating revenues                               |       | 2,992                            |       | 2,134 |   |
| **Operating Expenses:**                                |       |                             |       |   |   |
| Lease operating                                        |       | 570                              |       | 530 |   |
| Production and ad valorem taxes                        |       | 196                              |       | 205 |   |
| Depletion and depreciation                             |       | —                           |       | 273 |   |
| Accretion of discount on asset retirement  obligations |       | —                           |       | 2 |   |
| Interest expense, net                                  |       | 34                               |       | 96 |   |
| Total operating expenses                               |       | 800                              |       | 1,106 |   |
|                                                   |       |                             |       |   |   |
| **Income before income taxes**                         |       | 2,192                            |       | 1,028 |   |
| ** **                                             |       |                             |       |   |   |
| Income tax provision                                   |       | (801                             | )          | (370 | ) |
|                                                   |       |                             |       |   |   |
| **Income from discontinued  operations**               |       | $                                | 1,391      |   | $ | 658 |   |

 

The pro forma balancesheet presented as part of our consolidated balance sheets reflects the sale of“assets held for sale”; gain on sale of Pantwist, LLC (net of related incometaxes); and application of cash transaction proceeds received on October 1,2008 totaling $42.7 million to paydown long-term debt. We incurred $0.6million of fees associated with the sale. Accordingly, long-term debt is fullyrepaid to a zero balance at September 30, 2008.  The consolidated pro forma balance sheetreflects the sale as if it had occurred on September 30, 2008.

 

The pro forma statementof operations information presented with our consolidated statement ofoperations reflects the gain on sale of Pantwist, LLC (net of related taxes) asif it had occurred on July 1, 2008.

 

** 3.   COMMON STOCK ISSUANCE**

 

On July 1, 2008, wecompleted the sale of 7,000,000 shares of our common stock through anunderwritten offering at a share price of $8.00 per share ($7.75 net to us)resulting in net proceeds of approximately $53.9 million afterunderwriting discounts and commissions and expenses.

 

We used the net proceedsfrom the offering to pay down debt which will subsequently be drawn in order tofinance (i) existing development activities in certain core areas such as thePanhandle and Cato properties, (ii) selective acquisitions and (iii) generalcorporate purposes.

 

** 4.   LONG-TERM DEBT**

 

At September 30, 2008and June 30, 2008, the outstanding amount due under the credit agreementswas $42.7 million and $73.5 million, respectively.

 

On September 30, 2008,we borrowed suchamounts necessary under the senior credit agreement to payoff the entire outstanding $15.0 million principal due under our subordinatedcredit agreement, interest expense and a prepayment premium of $0.3 million.  In conjunction with the payoff, we terminatedthe subordinated credit agreement.  The outstanding balance under thesubordinated credit agreement had an interest rate of 8.50%.

 

8

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As of September 30, 2008, the senior credit agreement is our onlycurrent source of borrowing and the average interest rate was 5.19%.  AtSeptember 30, 2008, we were in compliance with the senior credit agreementdebt covenants.

 

On October 1, 2008, werepaid all outstanding principal and interest under the senior credit agreementwith the proceeds from the sale of Pantwist, LLC, as discussed in Note 2, andother available cash.  As of October 1, 2008, our available borrowingbase under the senior credit agreement remains at $60.0 million afterconsideration for the sale of Pantwist, LLC. We expect to draw down on the senior credit agreementin order to subsequently finance (i) existing development activities incertain core areas such as the Panhandle and Cato properties, (ii) selectiveacquisitions and (iii) general corporate purposes.

 

** 5.   COMMODITY DERIVATIVES**

 

Pursuant to our seniorcredit agreement discussed in Note 4, we are required to enter intocommodity derivative contracts to mitigate price risk on at least 50% and nogreater than 85% of our crude oil and natural gas production volumesattributable to proved producing reserves, for at least three years as of theend of each six month period ending thereafter.

 

As of September 30,2008, we maintain the following “costless collar” financial contracts:

 
| **Time Period**    | ** ** | **Floor  Oil Price** | ** ** | **Ceiling  Oil Price** | ** ** | **Barrels  Per Day** | ** ** | **Floor  Gas Price** | ** ** | **Ceiling  Gas Price** | ** ** | **Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per Day** | ** ** |
|-------------------------|------------|---------------------------|------------|-----------------------------|------------|---------------------------|------------|---------------------------|------------|-----------------------------|------------|-----------------------|------------|--------------------------------------------------------|------------|
| 4/1/08 -  12/31/08 |       | $                         | 80.00      |                        | $          | 117.50                    |       | 367                       |       | $                           | 7.75       |                  | $          | 11.40                                                  |       | 1,867 |   | 678 |   |
| 1/1/09 -  12/31/09 |       | $                         | 80.00      |                        | $          | 110.90                    |       | 367                       |       | $                           | 7.75       |                  | $          | 10.60                                                  |       | 1,667 |   | 644 |   |
| 1/1/10 -  12/31/10 |       | $                         | 80.00      |                        | $          | 108.20                    |       | 333                       |       | $                           | 7.75       |                  | $          | 9.85                                                   |       | 1,567 |   | 594 |   |
| 1/1/11 -  3/31/11  |       | $                         | 80.00      |                        | $          | 107.30                    |       | 333                       |       | $                           | 7.75       |                  | $          | 11.60                                                  |       | 1,467 |   | 578 |   |
| 4/1/08 -  12/31/08 |       | $                         | 85.00      |                        | $          | 110.60                    |       | 267                       |       | $                           | 8.00       |                  | $          | 10.90                                                  |       | 1,233 |   | 472 |   |
| 1/1/09 -  12/31/09 |       | $                         | 85.00      |                        | $          | 104.40                    |       | 233                       |       | $                           | 8.00       |                  | $          | 10.15                                                  |       | 1,133 |   | 422 |   |
| 1/1/10 -  12/31/10 |       | $                         | 85.00      |                        | $          | 101.50                    |       | 233                       |       | $                           | 8.00       |                  | $          | 9.40                                                   |       | 1,033 |   | 406 |   |
| 1/1/11 -  3/31/11  |       | $                         | 85.00      |                        | $          | 100.50                    |       | 200                       |       | $                           | 8.00       |                  | $          | 11.05                                                  |       | 967 |   | 361 |   |

 

As of September 30,2008, we maintain the following financial “floor price” contracts:

 
| **Time Period**   | ** ** | **Floor  Oil Price** | ** ** | **Barrels  per Day** | ** ** | **Floor  Gas Price** | ** ** | **Gas Mcf  per Day** | ** ** | **Barrels of  Equivalent  Oil per Day** | ** ** |
|------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|--------------------------------|------------|--------------------------------------------------------|------------|
| 1/1/08 - 12/31/08 |       | $                         | 55         |                      | 477        |                      | $          | 7.50                           |       | 1,529                                                  |       | 732 |   |
| 1/1/08 - 12/31/08 |       | $                         | 60         |                      | 66         |                      | $          | 7.60                           |       | 592                                                    |       | 165 |   |
| 1/1/09 - 4/30/09  |       | $                         | 60         |                      | 60         |                      | $          | 7.60                           |       | 567                                                    |       | 155 |   |
| 1/1/09 - 12/31/09 |       | $                         | 55         |                      | 395        |                      | $          | 7.60                           |       | 1,644                                                  |       | 669 |   |
| 1/1/10 - 6/30/10  |       | $                         | 55         |                      | 365        |                      | $          | 7.00                           |       | 1,657                                                  |       | 641 |   |
| 7/1/10 - 12/31/10 |       | $                         | 55         |                      | 391        |                      | $          | 7.50                           |       | 1,957                                                  |       | 717 |   |

 

During October 2008,we sold the “floor price” contracts covering July 2010 to December 2010for $0.6 million to our counterparty, and had a realized gain of $0.1 million.All currently remaining commodity derivative contracts are with Union Bank ofCalifornia, N.A., our administrative agent for our credit agreement.

 

The total volumescovered by costless collars and price floors detailed in the above tables isgreater than 85% of our crude oil and natural gas production volumesattributable to proved developed producing reserves through December 2010;however, the lenders under our senior credit agreement have approved allcommodity derivative contracts.

 

9

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During the three monthsended September 30, 2008 and 2007, there were settlements under ourcommodity derivatives, due to us and paid by us, that are accrued as realizedgains or losses on commodity derivatives in our consolidated statements ofoperations that are summarized as follows:

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **September 30,**           | ** ** |
| **In Thousands**                         | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Settlements received / accrued                |       | $                                | —     |   | $ | 296 |   |
| Settlements paid / accrued                    |       | (552                             | )          | — |   |
| Realized gain (loss) on commodity derivatives |       | $                                | (552       | ) | $ | 296 |   |

 

The cash settlementsreceived by us were cumulative monthly payments due to us since the NYMEXnatural gas and crude oil prices were lower than the “floor prices” set for therespective time period. The cash settlements paid/accrued by us were cumulativemonthly payments due to our counterparty since the NYMEX crude oil and/ornatural gas prices were higher than the “ceiling prices” set for the respectivetime period. The cash flows relating to the derivative instrument settlementsthat are due, but not cash settled are reflected in operating activities on ourconsolidated statements of cash flows. At September 30, 2008, we had noamounts due from or payable to our counterparty. At September 30, 2007, wehad $0.1 million due from our counterparty included in accounts receivable onour consolidated balance sheet.

 

We computed ourmark-to-market valuations used for our commodity derivatives based onassumptions regarding forward prices, volatility and the time value of money asdiscussed in Note 10. We compared our valuations to our counterparties’valuations to further validate our mark-to-market valuations. During the threemonths ended September 30, 2008, we recognized an unrealized gain oncommodity derivatives in our consolidated statements of operations amounting to$24.2 million as compared to an unrealized loss of $0.5 million for thethree months ended September 30, 2007.

 

As of September 30,2008, we had aggregate derivative assets and liabilities of $1.5 million and$3.7 million, respectively.  Theseamounts are based on our mark-to-market valuations of our derivativecommodities at September 30, 2008 and may not be indicative of actualfuture settlements.

 

** 6.   DEFERRED COMPENSATION**

 

As of September 30,2008, we have non-vested restricted shares totaling 656,667 shares to keyemployees pursuant to our 2005 Long-Term Incentive Plan, as summarized below:

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

 

The restricted share grantswill vest to the employees based on future years of service ranging from one tothree years depending on the life of the award agreement.  The fair valueis based on our actual stock price on the date of grant multiplied by thenumber of restricted shares granted.  As of September 30, 2008, thevalue of non-vested restricted shares amounted to $4.6 million.  For thequarters ended September 30, 2008 and 2007, we have expensed $0.8 millionand $0.4 million, respectively, to stock compensation expense based onamortizing the fair value over the appropriate service period.  The forfeitures resulted from shares used tosatisfy employees’ tax withholding obligations related to the vesting of theirrestricted shares and the retirement of a key employee, which resulted in theforfeiture of unvested restricted shares.

 

10

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** 7.   STOCK OPTIONS**

 

For the quarter ended September 30,2008, we granted 231,850 stock options to non-executive employees from our 2005Long-Term Incentive Plan.  The optionswere granted with an exercise price equal to our market price at the date ofgrant and have ten-year contractual terms. These stock option awards vest over six months to three years ofcontinuous service.  The factors used tocalculate the fair value of these options are summarized in the table below.

 
| No. of options                                                                              |   | 231,850                    |   |
|--------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
| Risk free interest rate                                                                          |   | 3.07 – 3.39 | %      |
| Expected life                                                                                    |   | 5 years               |   |
| Expected volatility                                                                              |   | 55.8 – 56.6 | %      |
| Expected dividend yield                                                                          |   | 0                          | %      |
| Weighted average grant date fair value—exercise  prices equal to market value on grant date |   | $                          | 1.97   |   |
|                                                                                                  |        |                            |        |  |

 

The fair value of each stock option is estimated on the date of grantusing the Black-Scholes option-pricing model. Expected volatility is based onthe historical volatility of our common stock. We use historical data toestimate option exercise and employee termination within the valuation model.The expected lives of options granted represent the period of time that optionsgranted are expected to be outstanding. The risk-free interest rate for periodswithin the contractual life of the option is based on the five-year U.S.Treasury yield curve in effect at the time of the respective grant. Theexpected dividend yield reflects our intent not to pay dividends on our commonstock during the contractual periods.

 

A summary of outstandingoptions as of September 30, 2008 is as follows:

 
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Outstanding at June 30, 2008      |       | 1,084,051  |       | $                                      | 5.71       |   |
| Options granted                        |       | 231,850    |       | $                                      | 3.84       |   |
| Options forfeited                      |       | (21,500    | )          | $                                      | 5.29       |   |
| Outstanding at September 30, 2008 |       | 1,294,401  |       | $                                      | 5.38       |   |

 

Based on our $2.31 stockprice at September 30, 2008, there was no intrinsic value of the optionsoutstanding and exercisable.

 

Total options exercisable at September 30,2008 amounted to 561,803 shares and had a weighted average exercise price of$5.75.  At September 30, 2007, total options exercisable amounted to275,000 shares and had a weighted average exercise price of $5.21.  Uponexercise, we issue the full amount of shares exercisable per the term of theoptions from new shares. We have no plans to repurchase those shares in thefuture.

 

For each of the quartersended September 30, 2008 and 2007, we recorded charges to stockcompensation expense of $0.2 million for the estimated fair value of theoptions granted to our directors and employees.

 

** 8.   NET INCOME (LOSS) PER COMMON SHARE**

 

Basic net income (loss) percommon share is computed by dividing the net income (loss) attributable tocommon shareholders by the weighted average number of shares of common stockoutstanding less unvested restricted shares during the period.  Diluted net income (loss) per common share iscomputed in the same manner, but also considers the effect of common stockshares underlying stock options, the preferred stock, paid-in-kind (“PIK”)dividends and unvested restricted stock.

 

The following tablereconciles earnings and shares used in the computation of basic and dilutedearnings per share for the three months ended September 30, 2008:

 

11

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| **In thousands, except per share data** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **Earnings  per Share** | ** ** |
|------------------------------------------------------------------|------------|--------------|------------|------------|------------|-------------------------|------------|
| Basic                                                            |       | $            | 11,818     |       | 45,338     |                    | $          | 0.26 |   |
|                                                             |       |         |       |       |       |                    |       |
| Effect of dilutive securities:                                   |       |         |       |       |       |                    |       |
| Conversion of preferred stock and PIK dividends                  |       | 936          |       | 8,502      |       |                    |       |
| Restricted shares                                                |       |         |       | 657        |       |                    |       |
| Stock options                                                    |       |         |       | 7          |       |                    |       |
| Diluted                                                          |       | $            | 12,754     |       | 54,504     |                    | $          | 0.23 |   |

 

As of September 30,2007, shares of common stock underlying the following items summarized belowwere not included in the weighted average shares outstanding for the threemonths ended September 30, 2007 as their effects would have been anti-dilutive.

 
| Stock options                |   | 811,513   |   |
|------------------------------|--------|-----------|--------|
| Warrants                     |   | 1,646,061 |   |
| Preferred stock              |   | 8,541,913 |   |
| PIK dividends                |   | 396,502   |   |
| Non-vested restricted shares |   | 465,000   |   |

 

** 9.   RELATED PARTY TRANSACTIONS**

 

Pursuant to an agreement dated December 16, 2004, as amended, weagreed with R.C. Boyd Enterprises, a Delaware corporation, to become the leadsponsor of a television production called Honey Hole (“Honey Hole Production”).As part of our sponsorship, we are able to provide fishing and outdooropportunities for children with cancer, children from abusive family situationsand children of military veterans. For the three months ended September 30,2008 and 2007, we paid $37,500 for each quarter to R.C. Boyd Enterprises, theowner of Honey Hole All Outdoors. Randall Boyd is the sole shareholder of R.C.Boyd Enterprises and is a member of our Board of Directors. Pursuant to a newagreement dated as of December 5, 2007, after December 31, 2008, wewill no longer be a Honey Hole Production sponsor. Our remaining commitment is$37,500 through December 31, 2008. We are entitled to receive twothirty-second commercials during all broadcasts of the Honey Hole Productionand receive opening and closing credits on each episode.

 

**10.   FAIR VALUE MEASUREMENTS**

 

Statement of FinancialAccounting Standards No. 157, *FairValue Measurements*, (“SFAS No. 157”) was issued by the FASB in September 2006.SFAS No. 157 defines fair value, establishes a framework for measuringfair value under GAAP and expands disclosures about fair value measurements.SFAS No. 157 applies to other accounting pronouncements that require orpermit fair value measurement. We adopted SFAS No. 157 on July 1,2008.  The initial adoption of SFAS 157had no material impact to our financial position, results of operations or cashflows.

 

Fair value is the price that would be received to sell an asset or theamount paid to transfer a liability in an orderly transaction between marketparticipants (an exit price) at the measurement date. Fair value is a marketbased measurement considered from the perspective of a market participant. Weuse market data or assumptions that market participants would use in pricingthe asset or liability, including assumptions about risk and the risks inherentin the inputs to the valuation. These inputs can be readily observable, marketcorroborated, or unobservable. Ifobservable prices or inputs are not available, unobservable prices or inputsare used to estimate the current fair value, often using an internal valuationmodel. These valuation techniques involve some level of management estimationand judgment, the degree of which is dependent on the item being valued.  We primarily apply a market approach for recurringfair value measurements using the best available information while utilizingvaluation techniques that maximize the use of observable inputs and minimizethe use of unobservable inputs.  Ourvaluation includes the effect of potential non-performance by thecounterparties.

 

12

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Beginning July 1,2008, assets and liabilities recorded at fair value are categorized based uponthe level of judgment associated with the inputs used to measure their fairvalue.  SFAS 157 establishes a fair valuehierarchy that prioritizes the inputs used to measure fair value. The hierarchygives the highest priority to quoted prices in active markets for identicalassets or liabilities (Level 1 measurement) and the lowest priority tounobservable inputs (Level 3 measurement). We classify fair value balancesbased on the observability of those inputs. The three levels of the fair valuehierarchy are as follows:

 

Level 1—Quoted prices in active markets for identicalassets or liabilities that we have the ability to access. Active markets arethose in which transactions for the asset or liability occur in sufficientfrequency and volume to provide pricing information on an ongoing basis.

 

Level 2—Inputs are other than quoted prices in activemarkets included in Level 1, which are either directly or indirectlyobservable. These inputs are either directly observable in the marketplace orindirectly observable through corroboration with market data for substantiallythe full contractual term of the asset or liability being measured.

 

Level 3—Inputs reflect management’sbest estimate of what market participants would use in pricing the asset orliability at the measurement date. Consideration is given to the risk inherentin the valuation technique and the risk inherent in the inputs to the model.

 

In valuing certaincontracts, the inputs used to measure fair value may fall into different levelsof the fair value hierarchy. For disclosure purposes, assets and liabilitiesare classified in their entirety in the fair value hierarchy level based on thelowest level of input that is significant to the overall fair valuemeasurement. Our assessment of the significance of aparticular input to the fair value measurement requires judgment and may affectthe placement within the fair value hierarchy levels.

 

Thefair value of our derivative contracts are measured using Level 2 and Level 3inputs.  The derivative assets andliabilities were classified as Level 3 due to the subjectivity of our valuation for the effectof our own credit risk.

 

Ourasset retirement obligation is measured using primarily Level 3 inputs. Thesignificant unobservable inputs to this fair value measurement includeestimates of plugging, abandonment and remediation costs, inflation rate andwell life. The inputs are calculated based on historical data as well ascurrent estimated costs.

 

Theestimated fair values of derivatives included in the consolidated balance sheetat September 30, 2008 are summarized below. The decrease in the currentand noncurrent derivative liabilities from June 30, 2008 to September 30,2008 is primarily attributable to the effect of lower crude oil and natural gasprices.

 
| **In thousands**                              | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------------|------------|
| Derivative  assets:                                |       |                                                  |       |
| Natural gas collars and price floors -  current    |       | $                                                     | 893        |   |
| Natural gas collars and price floors -  noncurrent |       | 526                                                   |       |
| Crude oil collars and price floors -  noncurrent   |       | 116                                                   |       |
| Derivative  liabilities:                           |       |                                                  |       |
| Crude oil collars and price floors -  current      |       | (912                                                  | )          |
| Crude oil collars and price floors -  noncurrent   |       | (2,681                                                | )          |
| Natural gas collars and price floors -  noncurrent |       | (94                                                   | )          |
| Net  derivative liability                          |       | $                                                     | (2,152     | ) |
| Asset  retirement obligation                       |       | $                                                     | (3,365     | ) |

 

Thefollowing table shows the reconciliation of changes in the fair value of thenet derivative liability and asset retirement obligation classified as Level 3in the fair value hierarchy for the quarter ended September 30, 2008.

 

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| ** **                         | ** ** | **Net**        | ** ** | **Asset**      | ** ** |
|------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                         | ** ** | **Derivative** | ** ** | **Retirement** | ** ** |
| **In thousands**              | ** ** | **Liability**  | ** ** | **Obligation** | ** ** |
| Balance at July 1, 2008       |       | $              | (26,243    | )              | $          | 3,403 |   |
| Unrealized gain                    |       | 24,235         |       | —         |       |
| Realized loss                      |       | (144           | )          | —         |       |
| Accretion of discount              |       | —         |       | 77             |       |
| Sale of Pantwist, LLC (Note 2)     |       | —         |       | (90            | )          |
| Liabilities settled                |       | —         |       | (25            | )          |
| Balance at September 30, 2008 |       | $              | (2,152     | )              | $          | 3,365 |   |

 

**11.   IMPAIRMENT OF LONG-LIVED ASSET**

 

In light of current commodity prices and our reviseddrilling capital budget, we believe there is uncertainty in the likelihood ofour developing Corsicana’s proved undeveloped reserves within the next fiveyears.  Therefore, we have recorded apre-tax $3.5 million impairment on our Corsicana oil and gas properties.  Fair value was determined using estimates offuture net cash flows, discounted to a present value.

 

**12.   COMMITMENTS AND CONTINGENCIES**

 

***Burnett Case***

 

On March 23, 2006,the following lawsuit was filed in the 100th Judicial District Court inCarson County, Texas; Cause No. 9840, The Tom L. and Anne BurnettTrust, by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr., GeorgeBeggs, III and Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr;and Burnett Ranches, Ltd. v. Cano Petroleum, Inc., W.O. Energyof Nevada, Inc., W. O. Operating Company, Ltd, andWO Energy, Inc. The plaintiffs claim that the electrical wiring andequipment of Cano or certain of its subsidiaries relating to oil and naturalgas operations started a wildfire that began on March 12, 2006 in CarsonCounty, Texas.

 

The plaintiffs (i) allegenegligence and gross negligence and (ii) seek damages, including, but notlimited to, damages for damage to their land and livestock, certain expensesrelated to fighting the fire and certain remedial expenses totalingapproximately $1.7 million to $1.8 million. In addition, theplaintiffs seek (i) termination of certain oil and natural gas leases, (ii) reimbursementfor their attorney’s fees (in the amount of at least $549,000) and (iii) exemplarydamages. The plaintiffs also claim that Cano and its subsidiaries are jointlyand severally liable as a single business enterprise and/or a generalpartnership or de facto partnership. The owner of the remainder of the mineralestate, Texas Christian University, intervened in the suit on August 18,2006, joining Plaintiffs’ request to terminate certain oil and gas leases.

 

On June 21, 2007,the Judge of the 100th Judicial District Court issued a FinalJudgment (a) granting motions for summary judgment in favor of Cano andcertain of its subsidiaries on plaintiffs’ claims for (i) breach ofcontract/termination of an oil and gas lease; and (ii) negligence; and (b) grantingthe plaintiffs’ no-evidence motion for summary judgment on contributorynegligence, assumption of risk, repudiation and estoppel affirmative defensesasserted by Cano and certain of its subsidiaries. The Final Judgment has beenappealed.

 

***Other Cases***

 

On April 28, 2006,the following lawsuit was filed in the 31st Judicial DistrictCourt of Roberts County, Texas: Cause No. 1922, Robert and Glenda Adcock,et al. v. Cano Petroleum, Inc., W.O. Energy of 

 

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Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. (“Adcock”).The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) allege negligence, res ipsa loquitor, trespass and nuisanceand (ii) seek damages, including, but not limited to, damages to theirland, buildings and livestock and certain remedial expenses totaling$5,439,958. In addition, the plaintiffs seek (i) reimbursement for theirattorney’s fees and (ii) exemplary damages. The plaintiffs also claim thatCano and its subsidiaries are jointly and severally liable as a single businessenterprise and/or a general partnership or de facto partnership. By SettlementAgreement and Release signed by all parties by November 5, 2008, theclaims of all plaintiffs in this suit were resolved and will be dismissed withprejudice.  This Settlement Agreement andRelease does not affect the claims of any Intervenors in this matter, exceptthose of Abraham Brothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abrahamand Jason M. Abraham.

 

On July 6, 2006,Anna McMordie Henry and Joni McMordie Middleton intervened in the Adcock case.The intervenors (i) allege negligence and (ii) seek damages totaling$64,357 as well as exemplary damages.

 

On July 20, 2006,Abraham Brothers, LP, Edward C. Abraham, Salem A. and Ruth AnnAbraham and Jason M. Abraham intervened in the Adcock case. The intervenors(i) allege negligence, nuisance, and trespass and (ii) seek damages,including, but not limited to, damages to their land, buildings and livestockand certain remedial expenses totaling $3,252,862. In addition, the intervenorsseek (i) reimbursement for their attorney’s fees and (ii) exemplarydamages. The intervenors also claim that Cano and its subsidiaries are jointlyand severally liable as a single business enterprise and/or a generalpartnership or de facto partnership. The claims of Abraham Brothers, LP,Edward C. Abraham, Salem A. and Ruth Ann Abraham and Jason M. Abraham (alongwith those asserted by Abraham Equine, Inc. discussed below) were resolvedthrough a Settlement Agreement and Release effective October 12, 2008 andwill be dismissed with prejudice.  ThisSettlement Agreement and Release does not affect the claims of any otherPlaintiff or Intervenor in the Adcock matter.

 

On August 9, 2006,Riley Middleton intervened in the Adcock case. The intervenor (i) allegesnegligence and (ii) seeks damages totaling $233,386 as well as exemplarydamages.

 

On April 10, 2006,the following lawsuit was filed in the 31st Judicial District Court ofRoberts County, Texas, Cause No. 1920, Joseph Craig Hutchison and JudyHutchison v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd, and WO Energy, Inc. (“Hutchinson”).The plaintiffs claim that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiffs (i) allege negligence and trespass and (ii) seek damagesof $621,058, including, but not limited to, damages to their land and certainremedial expenses. In addition, the plaintiffs seek exemplary damages.

 

On May 1, 2006, thefollowing lawsuit was filed in the 31st Judicial District Court of RobertsCounty, Texas: Cause No. 1923, Chisum FamilyPartnership, Ltd. v. Cano, W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd. and WO Energy, Inc. (“Chisum”).The plaintiff claims that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiff (i) alleges negligence and trespass and (ii) seeks damagesof $53,738.82, including, but not limited to, damages to their land and certainremedial expenses. In addition, the plaintiffs seek exemplary damages.

 

On August 9, 2006,the following lawsuit was filed in the 233rd Judicial District Court ofGray County, Texas, Cause No. 34,423, Yolanda Villarreal, Individually andon behalf of the Estate of Gerardo Villarreal v. Cano Petroleum, Inc.,W.O. Energy of Nevada, Inc., W. O. OperatingCompany, Ltd., and WO Energy, Inc. (“Villarreal”). Theplaintiffs claim that the electrical wiring and equipment of Cano or certain ofits subsidiaries relating to oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County, Texas. The plaintiffs (i) allegenegligence and (ii) seek damages for past and future financial support inthe amount of $586,334, in addition to undisclosed damages for wrongful deathand survival damages, as well as exemplary damages, for the wrongful death ofGerardo Villarreal who they claim died as a result of the fire. The plaintiffsalso claim that Cano and its subsidiaries are jointly and severally liableunder vicarious liability theories. On 

 

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August 22,2006, relatives of Roberto Chavira intervened in the case alleging similarclaims and seeking damages for lost economic support and lost householdservices in the amount of $894,078, in addition to undisclosed damages forwrongful death and survival damages, as well as exemplary damages regarding thedeath of Roberto Chavira.

 

On March 14, 2007,the following lawsuit was filed in 100th Judicial District Court in CarsonCounty, Texas; Cause No. 9994, Southwestern Public Service Company d/b/aXcel Energy v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd, and WO Energy, Inc. (“SPS”).The plaintiff claims that the electrical wiring and equipment of Cano orcertain of its subsidiaries relating to oil and gas operations started awildfire that began on March 12, 2006 in Carson County, Texas. Theplaintiff (i) alleges negligence and breach of contract and (ii) seeks$1,876,000 in damages for loss and damage to transmission and distributionequipment, utility poles, lines and other equipment. In addition, the plaintiffseeks reimbursement of its attorney’s fees.

 

On May 2, 2007, thefollowing lawsuit was filed in the 84th Judicial District Courtof Hutchinson County, Texas, Cause No. 37,619, Gary and Genia Burgess,et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Burgess”).Eleven plaintiffs claim that electrical wiring and equipment relating to oiland gas operations of the Company or certain of its subsidiaries started awildfire that began on March 12, 2006 in Carson County, Texas. Five of theplaintiffs are former plaintiffs in the Adcock matter. The plaintiffs (i) allegenegligence, res ipsa loquitor, nuisance, and trespass and (ii) seekdamages, including, but not limited to, damages to their land, buildings andlivestock and certain remedial expenses totaling approximately $1,997,217.86.In addition, the plaintiffs seek (i) reimbursement for their attorney’sfees and (ii) exemplary damages. The plaintiffs also claim that Cano andits subsidiaries are jointly and severally liable as a single businessenterprise and/or as a partnership or de facto partnership. By SettlementAgreement and Release signed by all parties on November 5, 2008, theclaims of all plaintiffs in this suit were resolved and will be dismissed withprejudice.

 

On May 15, 2007,William L. Arrington, William M. Arrington and Mark and Le’AnnMitchell intervened in the SPS case. The intervenors (i) allegenegligence, res ipsa loquitor, nuisance, and trespass and (ii) seekdamages, including, but not limited to, damages to their land, buildings andlivestock and certain remedial expenses totaling approximately $118,320. Inaddition, the intervenors seek (i) reimbursement for their attorney’s feesand (ii) exemplary damages. The intervenors also claim that Cano and itssubsidiaries are jointly and severally liable as a single business enterpriseand/or a general partnership or de facto partnership. By Settlement Agreementand Release signed by all parties on November 5, 2008, the claims of theseIntervenors were resolved and will be dismissed with prejudice.  This Settlement Agreement and Release doesnot affect the claims of any other Plaintiff or Intervenor in this matter.

 

On September 25,2007, the Texas Judicial Panel on Multidistrict Litigation granted CanoPetroleum, Inc., W.O. Energy of Nevada, Inc.,W. O. Operating Company, Ltd, and WO Energy, Inc.’s Motionto Transfer Related Cases to Pretrial Court pursuant to Texas Rule ofJudicial Administration 13. The panel transferred all pending cases (Adcock,Chisum, Hutchison, Villarreal, SPS, and Burgess, identified above, andValenzuela, Abraham Equine, Pfeffer, and Ayers, identified below) that assertclaims against the Company and its subsidiaries related to wildfires beginningon March 12, 2006 to a single pretrial court for consideration of pretrialmatters. The panel transferred all then-pending cases to the Honorable PaulDavis, retired judge of the 200th District Court of Travis County, Texas,as Cause No. D-1-GN-07-003353.

 

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 Hutchison case. The Trustclaims that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and gas operations started a wildfire that beganon March 12, 2006 in Carson County, Texas. The Trust (i) allegesnegligence and trespass and (ii) seeks damages of $46,362.50, including,but not limited to, damages to land and certain remedial expenses. In addition,the Trust seeks exemplary damages.

 

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

 

On January 10,2008, Philip L. Fletcher intervened in the consolidated case in the200th District Court of Travis County, Texas as part of the SPS case. Theintervenor (i) alleges negligence, trespass and nuisance and (ii) seeksdamages of $120,408, including, but not limited to, damages to his livestock,attorney’s fees and exemplary damages. The intervenor also claims that Cano andits subsidiaries are jointly and severally liable as a single business enterpriseand/or as a partnership or de facto partnership.

 

On January 15,2008, the Jones and McMordie Ranch Partnership intervened in the consolidatedcase in the 200th District Court of Travis County, Texas as part of theSPS case. The intervenor (i) alleges negligence, trespass and nuisance and(ii) seeks damages of $86,250.71, including, but not limited to, damagesto his livestock, attorney’s fees and exemplary damages. The intervenor alsoclaims that Cano and its subsidiaries are jointly and severally liable as asingle business enterprise and/or as a partnership or de facto partnership.

 

On February 11,2008, the following lawsuit was filed in the 48th JudicialDistrict Court of Tarrant County, Texas: Cause No. 048-228763-08, AbrahamEquine, Inc. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Abraham Equine”). Theplaintiff claims that the electrical wiring and equipment of Cano or certain ofits subsidiaries relating to oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County. The plaintiff (i) allegesnegligence, trespass and nuisance and (ii) seeks damages of $1,608,000,including, but not limited to, damages to its land, livestock and lost profits.In addition, the plaintiff seeks (i) reimbursement for its attorney’s feesand (ii) exemplary damages. The plaintiff also claims that Cano and itssubsidiaries are jointly and severally liable as a single business enterpriseand/or a general partnership or de facto partnership. Cano and its subsidiariesfiled a Motion to Dismiss or, in the Alternative, to Transfer Venue and aNotice of Tag Along transferring the case to the Multidistrict Litigation Casein the 200th Judicial District Court of Travis County, Texas.On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in theAlternative, to Transfer Venue and took the motion under advisement.  This suit (along with the claims of AbrahamBrothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abraham and JasonM. Abraham, discussed above) was resolved through a Settlement and ReleaseAgreement effective October 12, 2008 and will be dismissed with prejudice.

 

On March 10, 2008,the following lawsuit was filed in the 352nd Judicial DistrictCourt of Tarrant County, Texas, Cause No. 352-229256-08, Gary Pfeffer v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O.Operating, Ltd. and WO Energy, Inc. (“Pfeffer”). The plaintiff claimsthat the electrical wiring and equipment of Cano or certain of its subsidiariesrelating to oil and gas operations started a wildfire that began on March 12,2006 in Carson County. The plaintiff (i) alleges negligence, trespass andnuisance, (ii) seeks undisclosed damages for the wrongful death of hisfather, Bill W. Pfeffer, who he claims died as a result of the fire and (iii) seeksactual damages of $1,023,572.37 for damages to his parents’ home and property.In addition, the plaintiff seeks exemplary damages. The plaintiff also claimsthat Cano and its subsidiaries are jointly and severally liable as a generalpartnership or de facto partnership. Cano and its subsidiaries filed a Motionto Dismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Alongtransferring the case to the Multidistrict Litigation Case in the 200th JudicialDistrict Court of Travis County, Texas. On May 2, 2008, the 

 

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Courtheard Cano’s Motion to Dismiss or, in the Alternative, to Transfer Venue andtook the motion under advisement.

 

On March 11, 2008,the following lawsuit was filed in the 141st Judicial DistrictCourt of Tarrant County, Texas, Cause No. 141-229281-08, Pamela Ayers,et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Ayers”). The plaintiffsclaim that the electrical wiring and equipment of Cano or certain of itssubsidiaries relating to oil and gas operations started a wildfire that beganon March 12, 2006 in Carson County. The plaintiffs (i) allegenegligence and (ii) seek undisclosed damages for the wrongful death oftheir mother, Kathy Ryan, who they claim died as a result of the fire. Inaddition, the plaintiffs seek exemplary damages. The plaintiffs also claim thatCano and its subsidiaries are jointly and severally liable as a single businessenterprise and/or general partnership or de facto partnership. Cano and itssubsidiaries filed a Motion to Dismiss or, in the Alternative, to TransferVenue and a Notice of Tag Along transferring the case to the MultidistrictLitigation Case in the 200th Judicial District Court of TravisCounty, Texas. On May 2, 2008, the Court heard Cano’s Motion to Dismissor, in the Alternative, to Transfer Venue and took the motion under advisement.

 

On March 12, 2008,the following lawsuit was filed in the 17th Judicial DistrictCourt of Tarrant County, Texas, Cause No. 017-229316-08, The TravelersLloyds Insurance Company and Travelers Lloyds of Texas Insurance Company v.Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.,W.O. Operating, Ltd. and WO Energy, Inc. (“Travelers”). Theplaintiffs claim that the electrical wiring and equipment of Cano or certain ofits subsidiaries relating to oil and gas operations started a wildfire thatbegan on March 12, 2006 in Carson County. The plaintiffs (i) allegenegligence, res ipsa loquitor, and trespass and (ii) claim they aresubrogated to the rights of their insureds for damages to their buildings andbuilding contents totaling $447,764.60. The plaintiffs also claim that Cano andits subsidiaries are jointly and severally liable as a single businessenterprise and/or general partnership or de facto partnership.

 

On August 15, 2008,the trial court denied motions for summary judgment filed by Cano in theAdcock, Chisum, Hutchinson, Villarreal, SPS, Burgess, and Valenzuela cases. TheSPS case is set for jury trial on February 16, 2009. None of the otherabove-mentioned cases are currently set for trial; however, the Companyanticipates that the trial court will set these matters for jury trials.

 

Due to the inherent riskof litigation, the ultimate outcome of these cases and any jury trial isuncertain and unpredictable (see “*Part II, Item 1A – Risk Factors – Risks Related to Our Business –We are subject to several lawsuits relating to a fire that occurred on March 12,2006 in Carson County, Texas which may have an adverse impact on us*”).  At this time, Cano management believes that the lawsuits are without meritand will continue to vigorously defend itself and its subsidiaries,while seeking solutions to resolve these lawsuits in a cost-effective manner.

 

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

 

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

 

On February 9,2007, Cano and its subsidiaries entered into a Settlement Agreement and Releasewith the plaintiff pursuant to which in exchange for mutual releases, inaddition to the approximately $923,000 that we have been reimbursed byplaintiff, the plaintiff agreed to pay to Cano within 20 business days of February 9,2007 the amount of $6,699,827 comprised of the following: (a) the$1,000,000 policy limits of the primary policy; (b) the $5,000,000 policylimits of the excess policy; (c) $500,000 for future defense costs; (d) $144,000

 

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aspartial payment for certain unpaid invoices for litigation related expenses; (e) allapproved reasonable and necessary litigation related expenses through December 21,2006 that are not part of the above-referenced $144,000; and (f) certainspecified attorneys fees. During February 2007, we received the $6,699,827payment from Mid-Con. Of this $6,699,827 amount, the payments for policy limitsamounting to $6,000,000, in accordance with the senior credit agreement(Note 4), were placed in a controlled bank account and the use of theproceeds was specified to pay attorneys’ fees, settlement amounts and otherlitigation expenses incurred to defend and/or settle the fire litigation, andfor general corporate purposes. These proceeds have been fully expended.

 

On March 11, 2008,one of Cano’s subsidiaries entered into a tolling agreement with Kel-TexElectric, Inc. (“Kel-Tex”), an electrical contractor that was identifiedas a potentially responsible third party in connection with the claims relatedto the pending wildfire litigation against Cano and its subsidiaries.  In accordance with the terms of a SettlementAgreement and Release effective October 11, 2008, Kel-Tex  paid Cano for its full insurance policylimits totaling $6.0 million in exchange for a full release of any existing orfuture claims related to wildfires that began on March 12, 2006 in CarsonCounty, Texas, which was fully received on October 31, 2008.  This $6.0 million has been fully expended tocover portions of the settlements described above and is not included, as of September 30,2008, in the $6.0 million liability under deferred litigation credit aspresented on our consolidated balance sheet. Based on our knowledge and judgment of the facts as of September 30,2008, we believe the deferred litigation credit balance is adequate.

 

***SecuritiesLitigation against Outside Directors***

 

On October 2, 2008, the followinglawsuit (08 CV 8462) was filed in the United States District Court for theSouthern District of New York against David W. Wehlmann; Gerald W. Haddock;Randall Boyd; Donald W. Niemiec; Robert L. Gaudin; William O. Powell, III,and the underwriters allegingviolations of the federal securities laws. The plaintiff seeks to certify the lawsuit as a class action.  The lawsuit alleges that the prospectus forthe June 26, 2008 public offering of Cano common stock containedstatements regarding Cano’s proved reserve amounts and standards that werematerially false and overstated Cano’s proved reserves.  Messrs. Wehlmann, Haddock, Boyd,Niemiec, Gaudin and Powell were Cano outside directors on June 26,2008.  The lawsuit seeks an unspecifiedamount of damages for the class if the lawsuit is certified as a class action.  Due to the inherent risk of litigation, theoutcome of this lawsuit is uncertain and unpredictable; however, at this time, managmentbelieves the lawsuit is without merit and is vigorously supporting its outsidedirectors in the defense of the claims against them.

 

***Other***

 

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

 

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**Item 2. Management’sDiscussion and Analysis on Financial Condition and Results of Operations**

 

**Forward-LookingStatements**

 

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 ofmany factors, including, but not limited to the volatility in prices for crudeoil and 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 followingdiscussion and analysis in conjunction with the consolidated financial statementsof Cano and subsidiaries and notes thereto, included herewith. This discussionshould not be construed to imply that the results discussed herein willnecessarily continue into the future, or that any conclusion reached hereinwill necessarily be indicative of actual operating results in the future. Suchdiscussion represents only the best present assessment of management.

 

**Operating Strategy**

 

We are an independent oil andnatural gas company that utilizes enhanced oil recovery (“EOR”) techniques to increaseproduction and reserves at our existing properties and properties acquired inthe future.  Our assets are located onshore U.S. in Texas, New Mexico andOklahoma. Our focus on domestic, mature oil fields eliminates exploration riskand the uncertainty associated with international development.  Weprimarily use waterflooding and EOR, such as alkaline/ surfactant/ polymer (“ASP”)technology to develop our properties.

 

We believe our current portfolio ofoil and natural gas properties provides ample opportunities to apply ouroperational strategy. As of June 30, 2008, pro forma for the sale ofPantwist, LLC as discussed in Note 2, we had proved reserves of 50,749 MBOE, ofwhich 8,717 MBOE were proved producing, 2,491 MBOE were proved non-producing,and 39,541 MBOE were proved undeveloped. Crude oil reserves accounted for 74%of our pro forma total proved reserves at June 30, 2008.

 

During the fiscal year ended June 30,2008 and continuing into our current fiscal year ending June 30, 2009 (“2009Fiscal Year”), our primary emphasis is to develop our existing oil and naturalgas properties through activities such as waterflooding and EOR technology.These development activities are more clearly defined in the next sectiontitled “Drilling Capital Development Update.”

 

***DrillingCapital Development Update***

 

For the 2009 Fiscal Year, we haverevised our drilling capital development budget from $97.5 million to$35.5 million due to the recent deterioration in the credit and equity markets,coupled with significantly lower crude oil and natural gas prices. The budgetrevised allocates capital as follows:

 

·                  $16.5 millionat the Cato Properties

·                  $12.4 millionat the Panhandle Properties

·                  $2.2 millionat the Nowata Properties

·                  $4.0 millionat the Desdemona Properties

·                  $0.4 millionat other projects

 

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Our capital development program includes the drilling of 21 new wells.The financing of our capital expenditures is discussed below under “Liquidityand Capital Resources.” The status of our capital development activity duringthe 2008 Fiscal Year and planned activity during the 2009 Fiscal Year issummarized as follows:

 

***        ****** Panhandle Properties.***    Production at the Cockrell Ranch Unitwaterflood has remained at approximately 80-100 net BOEPD for June 2008through September 2008.  During thefirst quarter, as a result of our previously announced surveillance program, weidentified and corrected injectivity issues in 16 of 62 total water injectionwells.  This work was completed in September 2008.  The Cockrell waterflood has been at fullinjection for only seven months.  As weare early in the life of this waterflood, the surveillance measures we havetaken are normal. Of note, there are areas of the flood that are respondingfavorably, with percentage of oil  in thetotal produced fluid in excess of 10%.

 

The next phase of the waterfloodproject at the Panhandle field consists of six separate “mini” phases onreduced well spacing that will allow Cano to accelerate field development.Tighter spacing and smaller development patterns should reduce permitting andresponse times. Our revised capital development plan provides for thedevelopment of only one “mini” phase this fiscal year. The Harvey Unit had itswaterflood permit application approved by the Texas Railroad Commission on October 20,2008. We will be ready to initiate injection by calendar year end 2008.  Net production at the Panhandle Propertiesfor September 2008 was approximately 610 BOEPD.

 

***        Cato Properties.***     In July 2008,we reinstated our drilling program and have drilled and completed eightadditional waterflood infill wells plus one water source well.  The revised capital development plan for the2009 Fiscal Year provides for the drilling of a total of 12 new waterfloodpattern wells and to initiate water injection. We received notice on September 9,2008 of final approval of the waterflood application by the New Mexico Oil andGas Conservation Commission. We currently have ten water injection wellson-line and anticipate being in positioned to initiate water injection in fouradditional wells by calendar year end. Net production for September 2008at the Cato Properties was approximately 340 BOEPD.

 

***        Desdemona Properties.***     Wewill test a number of Marble Falls and Barnett Shale zones utilizing a secondhydraulic fracture stimulation treatment in the first and second quarter. Wecontinue to monitor the pilot waterflood project.  We do not expect to see meaningful responsefrom the Duke Sand Waterflood during the 2009 Fiscal Year. Net production for September 2008at the Desdemona Properties was approximately 60 BOEPD.

 

***        Nowata Properties.***    Our ASPtertiary recovery pilot project, which has been in full operation since December 2007,has injected close to .18 PVI of ASP. Pore volume injection, or PVI, isthe amount of void space of a producing formation that has been displaced withwater or surfactants, polymers and other additive.  We expect an initial response to the ASPpilot by the end of the 2008 calendar year. We plan to continue injecting ASP and will drill four ASP Pilotobservation wells in the 2009 Fiscal Year. Net production for September 2008at the Nowata Properties was approximately 220 BOEPD.

 

***        Davenport Properties.***    Netproduction for September 2008 was approximately 70 BOEPD.

 

***        Corsicana Properties.***     Netproduction for September 2008 was approximately 2 BOEPD. In light of current commodity prices and ourrevised drilling capital budget (as previously discussed), we believe there isuncertainty in the development of Corsicana’s proven undeveloped reserves.  Therefore, we have recorded a pre-tax $3.5million impairment of our Corsicana oil and gas properties.

 

**Liquidity andCapital Resources**

 

Asdiscussed in Note 3, we completed the issuance of common stock on July 1,2008, receiving net proceeds of $53.9 million for the issuance of 7.0 millionshares of our common stock.  The net proceeds were initially used to paydown our long-term debt due under the senior credit agreement.

 

Asdiscussed in Note 2, on October 1, 2008, we sold our wholly-ownedsubsidiary, Pantwist, LLC (“Pantwist”), for $42.7 million ($40.1 million net ofcertain closing adjustments and broker fees).

 

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Asa direct result of the common stock issuance and sale of Pantwist, we fullyrepaid our long-term debt and terminated our subordinated debt agreement, whichhad an 8.50% interest rate.  As discussedin Note 4, our  borrowing base is $60.0million under the senior credit agreement. We intend to draw down the available borrowings to fund our capitaldevelopment program as previously discussed under “*Drilling Capital Development Update*”, forselective acquisitions and for general corporate purposes.

 

AtSeptember 30, 2008, our cash balance was $11.5 million.  As shown in the pro forma information in theconsolidated balance sheets and further discussed in Note 2, after thecompletion of the Pantwist sale and paydown of long-term debt, our pro formacash balance is $6.8 million.  At September 30,2008, our cash balance along with the balances for accounts payable and accruedliabilities were higher than normal as we waited to complete the sale ofPantwist, LLC on October 1, 2008.

 

Forthe three months ended September 30, 2008, we generated cash fromoperations of $2.7 million, which is a $1.6 million increase as compared to theprior year quarter of $1.1 million. The $1.6 million increase is attributed tohigher revenues partially offset by higher operating expenses, as furtherdiscussed under *“Results of Operations.”*

 

DuringOctober 2008, we sold a previously purchased financial contract covering July 2010through December 2010 consisting of price floors for $0.6 million.  All costless collars and other price floorcontracts, as discussed in Note 5, remain in place.  The lead lender for our senior debtagreement, Union Bank of California, N.A., is the counterparty to all remainingderivatives.

 

Asdiscussed in Note 12, as of October 31, 2008, Kel-Tex Electric, Inc.paid Cano its full insurance policy limits of $6.0 million in exchange for afull release of any existing or future claims related to wildfires that beganon March 12, 2006 in Carson County, Texas. This $6.0 million has beenfully expended to cover the settlements discussed in Note 12.

 

Webelieve the combination of cash on hand, cash flow generated from operations,expected success of prior capital development projects and available debt issufficient to finance our operations, contractual obligations and capitalexpenditure program (as previously discussed in the section titled “*Drilling**CapitalDevelopment Update”)* through June 30, 2009.

 

OnDecember 28, 2007, our universal shelf registration statement was declaredeffective by the SEC for the issuance of common stock, preferred stock,warrants, senior debt and subordinated debt up to an aggregate amount of $150.0million.  After the issuance of common stock on July 1, 2008, we have$96.0 million of availability under this registration. We may periodicallyoffer one or more of these securities in amounts, prices and on terms to beannounced when and if the securities are offered. At the time any of thesecurities covered by the registration statement are offered for sale, aprospectus supplement will be prepared and filed with the SEC containingspecific information about the terms of any such offering.  We have noimmediate plans to utilize the universal shelf registration statement.

 

Historically, our primary sources ofcapital and liquidity have been issuance of equity securities, borrowings underour credit agreements, and cash flows from operating activities.

 

**Results ofOperations**

 

For the quarter ended September 30,2008 (“current quarter”), we had income applicable to common stock of $11.8million, which was $13.0 million higher as compared to the $1.2 million lossapplicable to common stock incurred for the quarter ended September 30,2007 (“prior year quarter”).  Positive factors included increased revenuesof $4.3 million, unrealized gains on commodity derivatives of $24.7 million andhigher income of $0.8 million from discontinued operations.  These positive factors were partially offsetby higher operating expenses of $8.2 million, and higher realized losses oncommodity derivatives of $0.8 million.

 

These items will be addressed in thefollowing discussion.

 

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***Operating Revenues***

 

The table below summarizes ouroperating revenues for the quarters ended September 30, 2008 and 2007.

 
| ** **                          | ** ** | **Quarter Ended September 30,** | ** ** | **Increase** | ** ** |
|-------------------------------------|------------|------------------------------------------------|------------|--------------|------------|
| ** **                          | ** ** | **2008**                                       | ** ** | **2007**     | ** ** | **(Decrease)** | ** ** |
| *Operating Revenues (In thousands)* |       | $                                              | 10,946     |         | $          | 6,587 |   | $ | 4,359 |   |
| Sales                               |       |                                           |       |         |       |   |   |
| ·  Oil (MBbls)       |       | 73                                             |       | 56           |       | 17 |   |
| ·  Gas (MMcf)        |       | 194                                            |       | 239          |       | (45 | ) |
| ·  Total (MBOE)      |       | 105                                            |       | 96           |       | 9 |   |
| Average Price                       |       |                                           |       |         |       |   |   |
| ·  Oil ($/ Bbl)      |       | $                                              | 111.88     |         | $          | 72.42 |   | $ | 39.46 |   |
| ·  Gas ($/ Mcf)      |       | $                                              | 14.04      |         | $          | 10.25 |   | $ | 3.79 |   |

 

The current quarter operating revenuesof $10.9 million represent an improvement of $4.3 million as compared to theprior year quarter of $6.6 million. The $4.3 million improvement is primarilyattributable to higher prices received for crude oil and natural gas sales of$3.3 million and $0.8 million, respectively, and higher oil sales of $0.8million, partially offset by lower gas sales of $0.6 million.  The higheroil sales were primarily attributed to the development activity at the CatoProperties, as previously discussed under the *“DrillingCapital Development Update.”* The decreased gas sales pertainprimarily from the Barnett Shale production from our Desdemona Properties dueto reduced development activity and lower gas production from our PanhandleProperties due to normal decline, partially offset by higher gas productionfrom the Cato Properties due to the aforementioned development activity.

 

The average price we received forcrude oil sales is generally at or above market prices received at the wellhead(other than at the Cato Properties). The average price we receive for naturalgas sales is approximately the market price received at the wellhead, adjustedfor the value of natural gas liquids, less transportation and marketingexpenses.

 

As discussed in Note 5, we havecommodity derivatives in place that provide for $80 to $85 crude oil floorprices and $7.50 to $8.00 natural gas floor prices. If crude oil and naturalgas NYMEX prices are lower than the floor prices, we will be reimbursed by ourcounterparty for the difference between the NYMEX price and floor price.

 

***Operating Expenses***

 

For the current quarter, our totaloperating expenses were $15.8 million, or $8.2 million higher than the prioryear quarter of $7.6 million. The $8.2 million increase resulted from animpairment of long-lived assets of $3.5 million, increased lease operatingexpenses of $2.5 million, higher general and administrative expenses of$1.2 million, higher production and ad valorem taxes of $0.6 million and higherdepletion and depreciation expense of $0.4 million.

 

Duringthe current quarter, we have recorded a pre-tax $3.5 million impairment on ourCorsicana oil and gas properties.  Inlight of current commodity prices and our revised drilling capital budget, webelieve there is uncertainty in the likelihood of our developing Corsicana’sproven undeveloped reserves within the next five years.  The fair value was determined using estimatesof future production volumes, prices and operating expenses, discounted to apresent value.

 

Our lease operating expenses (“LOE”)consists of costs of producing crude oil and natural gas such as labor,supplies, repairs, maintenance, and utilities. For the current quarter, our LOEwas $5.1 million, which is $2.5 million higher than the prior year quarter.  For the current quarter, our LOE per BOE,based on production, was $45.93 as compared to $25.86 for the prior yearquarter. We have incurred higher LOE due to increased workover activities atthe Panhandle Properties, higher electricity costs and increased downholechemical treatments. The workover 

 

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activities pertained to returningwells to production and are expected to result in increased production infuture months.  In general, secondary andtertiary LOE is higher than companies developing primary production becausefields are more mature and typically produce less oil and more water.  Weexpect the LOE per BOE to decrease during the 2009 Fiscal Year as we havesuccessfully negotiated service rate decreases with vendors and expectproduction increases from the waterflood and EOR development activities we haveimplemented and are implementing as discussed under the *“Drilling Capital Development Update*.”

 

Our general and administrative(G&A) expenses consist of support services for our operating activities andinvestor relations costs. For the current quarter, our G&A expenses totaled$4.9 million, which is $1.2 million higher than the prior year quarter of $3.6million. The primary reasons for the $1.2 million increase were higher legalexpenses pertaining to the fire litigation as discussed in Note 12; increasedstock compensation expense due to the issuance of restricted shares and stockoptions as discussed in Notes 6 and 7, respectively; and increased payrollcosts.

 

For the current quarter, ourproduction and ad valorem taxes were $1.1 million, which is $0.6 million higherthan the prior year quarter.  Theincrease is attributable to higher revenues and increased ad valorem taxes dueto notification of revisions in tax property valuations by taxing authoritiesfor the 2008 calendar year.  Therefore,the current quarter includes higher tax rates for the current quarter plus acharge for applying the rates to the first six months of the 2008 calendaryear.

 

For the current quarter, ourdepletion and depreciation expense was $1.2 million, or $0.4 million higherthan the prior year quarter.  This includes depletion expense pertainingto our oil and gas properties, and depreciation expense pertaining to our fieldoperations vehicles and equipment, gas plant, office furniture andcomputers.  For the current quarter, our depletion rate pertaining to ouroil and gas properties was $10.41 per BOE, as compared to prior year quarter of$7.18 per BOE due to higher rates for our Cato and Panhandle Properties basedon our reserve redetermination at June 30, 2008.

 

***Interest Expense***

 

The interest expense we incurred inthe current quarter of $0.1 million is comparable to the prior yearquarter.  Our interest expense for the current and prior year quarters isimpacted by $0.3 million and $0.5 million, respectively, of interest cost thatwas capitalized to waterflood and ASP projects as discussed under the *“Drilling Capital Development Update.”*

 

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

 

As discussed in Note 5, we haveentered into financial contracts to set price floors for crude oil and naturalgas, and to set price ceilings for crude oil.  For the current quarter, werecorded an unrealized gain of $24.2 million to reflect the fair value of thecommodity derivatives as of September 30, 2008.  For the prior yearquarter, we recorded an unrealized loss of $0.5 million.  By their nature,these commodity derivatives can be highly volatile to our earnings.  Afive percent change in these prices for our derivative instruments can impactearnings by approximately $0.1 million.

 

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

 

As discussed in Note 5, during thecurrent year quarter, we incurred a realized loss on our commodity derivativesamounting to $0.6 million.  For the prioryear quarter, we had a realized gain of $0.3 million.  If crude oil and natural gas NYMEX prices arelower than the floor prices, we will be reimbursed by our counterparty for thedifference between the NYMEX price and floor price. Conversely, if crude oiland natural gas NYMEX prices are higher than the ceiling prices, we will payour counterparty for the difference between the NYMEX price and floor price.

 

***Income Tax Benefit***

 

For the current quarter, we recordedan income tax expense of $8.1 million as compared to an income tax benefit of$0.1 million during the prior year quarter. Both quarterly tax amounts includetaxes related to discontinuedopeartions. The change is a direct result of the change in taxableincome and an increase in the current quarter’s state tax rate, resulting in anaggregate rate of 39%.  The income taxrate for the prior year quarter was 32%.

 

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***Preferred Stock Dividend***

 

The preferred stock dividend for thecurrent quarter of $0.9 million is comparable to the prior year quarter.

 

***Income from Discontinued Operations***

 

For the current and prior yearquarters, we had income from discontinued operations of $1.4 million and $0.7,respectively.  This represents the incomeattributable to the divested Pantwist operations as discussed in Note 2.

 

 ***New Accounting Pronouncements***

 

In February 2007, the FASBissued SFAS No. 159, *The Fair ValueOption for Financial Assets and Financial Liabilities*—*Including an amendment of FASB Statement No. 115*(“SFAS No. 159”). SFAS No. 159 permits entities to choose to measuremany financial instruments and certain other items at fair value that are notcurrently required to be measured at fair value. It provides entities with theopportunity to mitigate volatility in reported earnings caused by measuringrelated assets and liabilities differently without having to apply complexhedge accounting provisions. We have adopted SFAS No. 159 on July 1,2008. The adoption of SFAS No. 159 did not have a material impact on ourfinancial position, results of operations or cash flows.

 

In December 2007, the FASBissued SFAS No. 141 (revised 2007), *BusinessCombinations* (“SFAS No. 141R”). Among other things, SFAS No. 141Restablishes principles and requirements for how the acquirer in a businesscombination (i) recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquired business, (ii) recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase, and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS No. 141R is effective for fiscal yearsbeginning on or after December 15, 2008, with early adoption prohibited.This standard will change our accounting treatment for business combinations ona prospective basis.

 

In December 2007, the FASBissued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements, an Amendment of ARB No. 51*(“SFAS No. 160”). SFAS No. 160 establishes accounting and reportingstandards for noncontrolling interests in a subsidiary and for the deconsolidationof a subsidiary. Minority interests will be recharacterized as noncontrollinginterests and classified as a component of equity. It also establishes a singlemethod of accounting for changes in a parent’s ownership interest in asubsidiary and requires expanded disclosures. This statement is effective forfiscal years beginning on or after December 15, 2008, with early adoptionprohibited. We will adopt SFAS No. 161 on July 1, 2009. We do notexpect the adoption of this statement will have a material impact on ourfinancial position, results of operations or cash flows.

 

In March 2008, the FASB issuedSFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities—An Amendment of FASB Statement133* (“SFAS No. 161”). SFAS No. 161 amends and expands SFASNo. 133 to enhance required disclosures regarding derivatives and hedgingactivities. It requires companies to provide additional disclosure to discussthe uses of derivative instruments; the accounting for derivative instrumentsand related hedged items under SFAS No. 133; and how derivativeinstruments and related hedged items affect the company’s financial position,financial performance and cash flows. We will adopt SFAS No. 161 on July 1,2009. We do not expect the adoption of this statement will have a materialimpact on our financial position, results of operations or cash flows.

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk.**

 

See Notes 4, 5 and 10 regarding theupdates of our market risk for the quarter ended September 30, 2008.

 

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**Item 4. Controlsand Procedures.**

 

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

 

During the quarter ended September 30,2008, there was no change in our internal control over financial reporting thathas materially affected or is reasonably likely to materially affect ourinternal control over financial reporting.

 

**PART II— OTHER INFORMATION**

 

**Item 1. LegalProceedings.**

 

See Note 12 which is incorporatedinto this “Item 1. Legal Proceedings” by reference.

 

**Item 1A. Risk Factors.**

 

Due to the recent deterioration inthe credit and equity markets and significantly lower crude oil and natural gasprices and certain settlements regarding the fire litigation, we are updatingcertain of the risk factors that were included in our Annual Report on Form 10-Kfor the year-ended June 30, 2008.

 

**Risks Related to Our Industry**

 

***Oil and natural gas prices arevolatile. The recent decline in prices could adversely affect our financialposition, financial results, cash flows, access to capital and ability to grow.***

 

Our revenues, operating results, profitability and future rate ofgrowth depend primarily upon the prices we receive for the oil and natural gaswe produce and sell. Prices also affect the amount of cash flow available forcapital expenditures and our ability to borrow money or raise additionalcapital. Historically, the markets for oil and natural gas have been volatileand they are likely to continue to be volatile. Wide fluctuations in oil andnatural gas prices may result from relatively minor changes in the supply ofand demand for oil and natural gas, market and political uncertainty and otherfactors that are beyond our control, including:

 

·                  worldwide and domestic demands and suppliesof oil and natural gas;

 

·                  weather conditions;

 

·                  the price and availability of alternativefuels;

 

·                  the availability of pipeline capacity;

 

·                  the price and level of foreign imports;

 

·                  domestic and foreign governmental regulationsand taxes;

 

·                  the ability of the members of theOrganization of Petroleum Exporting Countries to agree to and maintain oilprice and production controls;

 

·                  political instability or armed conflict inoil-producing regions; and

 

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·                  the overall economic environment.

 

These factors and the volatility of the energy markets make itextremely difficult to predict future oil and natural gas price movements withany certainty. The recent declines in oil and natural gas prices may not onlyreduce revenue, but could reduce the amount of oil and natural gas that we canproduce economically and, as a result, could have a material adverse effect onour financial condition, results of operations and reserves.

 

***The oil and natural gas industry iscapital intensive, and we may not be able to raise the capital needed in thefuture to conduct our operations as planned or make strategic acquisitions,especially in light of the current credit and equity markets.***

 

The oil and natural gas industry is capital intensive. We makesubstantial capital expenditures for the acquisition, exploration for anddevelopment of oil and natural gas reserves. Due to the current credit and equity markets and lower oil and naturalgas prices, we have reduced our capital budget for the fiscal year 2009.

 

Historically, we have financed capital expenditures primarily with cashgenerated by operations, proceeds from bank borrowings and sales of our equitysecurities. Our cash flow from operations and access to capital are subject toa number of variables, including:

 

·                  our proved reserves;

 

·                  the level of oil and natural gas we are ableto produce from existing wells;

 

·                  the prices at which oil and natural gas aresold; and

 

·                  our ability to acquire, locate and producenew reserves.

 

Any one of these variables can materially affect our ability to borrowunder our credit agreement.

 

If our revenues or the borrowing base under our credit agreementdecrease as a result of lower oil and natural gas prices, operatingdifficulties, declines in reserves or for any other reason, we may have limitedability to obtain the capital necessary to undertake or complete futuredrilling projects. We may, from time to time, seek additional financing, eitherin the form of increased bank borrowings, public or private sales of debt orequity securities or other forms of financing, or consider selling non-coreassets to raise additional operating capital. However, especially in light ofthe current credit and equity markets, we may not be able to obtain additionalfinancing or make sales of non-core assets upon terms acceptable to us.

 

**Risks Related to Our Business**

 

***If we cannot obtain sufficientadditional capital when needed, we will not be able to continue with ourbusiness strategy. In addition, significant infusions of additional capital mayresult in dilution to your ownership and voting rights in our securities.***

 

Our business strategy includes acquiring interests in mature oil fieldswith established reserves that may possess significant remaining upsideexploitation potential by implementing various secondary and tertiary enhancedoil recovery operations. We continue to evaluate acquiring undervaluedproperties that feature enhanced recovery opportunities. As we continue toevaluate acquisition candidates, we may require additional capital to financethe acquisitions as well as to conduct our EOR operations. Especially in lightof the current credit markets, we may not be able to obtain additional financingin sufficient amounts or on acceptable terms when needed, which could adverselyaffect our operating results and prospects. If we cannot raise the additionalcapital required to implement our business strategy, we may be required tocurtail operations or develop a different strategy, which could adverselyaffect our financial condition and results of operations. Further, any debtfinancing must be repaid and redeemable preferred stock must be redeemedregardless of whether or not we generate profits or cash flows from ourbusiness activities.

 

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Ifavailable in light of the current equity markets, equity financing may resultin dilution to existing stockholders and may involve securities that have rights,preferences, or privileges that are senior to our common stock.

 

***We are subject to many restrictionsunder our senior credit agreement which may adversely impact our futureoperations.***

 

We may depend on our senior credit agreement for future capital needs.As required by our senior credit agreement with our bank lenders, we havepledged substantially all of our oil and natural gas properties as collateralto secure the payment of our indebtedness. The senior credit agreementrestricts our ability to obtain additional financing, make investments, sellassets, grant liens, repurchase, redeem or retire our securities, enter intospecific transactions with our subsidiaries or affiliates and engage inbusiness combinations. The senior credit agreement prohibits us from declaringor paying dividends on our common stock. We are also required to comply withcertain financial covenants and ratios.

 

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

 

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

 

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

 

Cano and certain of its subsidiaries are defendants in several lawsuitsrelating to a fire that occurred on March 12, 2006 in Carson County,Texas. The alleged damages include damage to land and livestock, remedialexpenses and claims relating to wrongful death. We have settled certain of thelawsuits. Currently, known aggregate actual damage claims are approximately$10,800,000. However, certain plaintiffs have not provided actual damage claimsfor any or all of their claims. These actual damage claims do not include theadditional claims by the plaintiffs for attorneys’ fees and exemplary damages,the potential amounts of which cannot be reasonably estimated. In February 2007,we entered into a Settlement Agreement with our insurance carrier pursuant towhich we received $6,699,827 in exchange for releasing the insurance carrierfrom any future claims. $6,000,000 of the amount received related to theinsurance policy limits and the remaining $699,827 related to the reimbursementof defense costs previously incurred by Cano. The $6,000,000 payment for policylimits, in accordance with the senior credit agreement, was placed in a controlledbank account and the use of the proceeds was specified to pay attorneys’ fees,settlement amounts, other litigation expenses incurred to defend and/or settlethe fire litigation, and for general corporate purposes. We have fully expendedthe $6,000,000 payment from fire litigation insurance proceeds.  On October 11, 2008, Kel-Tex Electric, Inc.committed to pay us $6,000,000 in exchange for a full release of any existingor future claims related to wildfires that began on March 12, 2006 inCarson County, Texas.  This $6,000,000was fully received by October 31, 2008 and has been fully expended tocover portions of the settlements entered into to date.  There is no remaining insurance coverage forthe fire litigation. We may not be able to settle any or all of the remainingfire litigation cases on acceptable terms and may not prevail in court on anyor all of such cases. If there is an adverse judgment entered against us in oneor more of the remaining fire litigation cases, based on the illiquid nature ofa significant portion of our assets, we may not be able to (i) post asufficient supersedeas bond during the appeal process of any adverse 

 

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judgment,which may permit the prevailing plaintiffs to attempt to execute on anyjudgment pending appeal, and/or (ii) satisfy the amount of any adversejudgment.

 

**Item 2.  Unregistered Sales ofEquity Securities and Use of Proceeds.**

 

The following shares of our common stock were delivered to us duringthe quarter ended September 30, 2008 to satisfy tax withholdingobligations relating to the vesting of restricted stock awards:

 
| **Period**                                              | ** ** | **Total  Number  of Shares  (or Units)  Purchased** | ** ** | **Average  Price Paid  per Share  (or Unit)** | ** ** | **Total Number of  Shares  (or Units)  Purchased as  Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum Number  (or Approximate  Dollar Value) of  Shares (or Units)  that May Yet Be  Purchased Under  the Plans or  Programs** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1, 2008 through July 31,  2008           |       | 22,975                                                        |       | $                                                            | 7.61       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |
|                                                    |       |                                                          |       |                                                         |       |                                                                                                                                          |       |                                                                                                                                                                                           |       |   |
| August 1, 2008 through August 31,  2008       |       | —                                                        |       | —                                                       |       | —                                                                                                                                        |       | —                                                                                                                                                                                         |       |
|                                                    |       |                                                          |       |                                                         |       |                                                                                                                                          |       |                                                                                                                                                                                           |       |
| September 1, 2008 through  September 30, 2008 |       | 22,758                                                        |       | $                                                            | 2.31       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |
|                                                    |       |                                                          |       |                                                         |       |                                                                                                                                          |       |                                                                                                                                                                                           |       |   |
| Total                                                   |       | 45,733                                                        |       | $                                                            | 4.97       |                                                                                                                                          | —     |                                                                                                                                                                                           | —     |   |

 

These shares were delivered by Morris B. Smith, Patrick McKinneyand Michael Ricketts pursuant to the terms of the Cano Petroleum, Inc.2005 Long-Term Incentive Plan, to satisfy tax withholding obligations relatedto the vesting of their restricted stock awards.

 

**Item 6. Exhibits.**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                |       | Purchase and Sale Agreement by and  among Cano Petroleum, Inc., as Seller, and Legacy Reserves Operating LP,  as Buyer, and Pantwist, LLC, as the Company, dated September 5, 2008  (The schedules and exhibits have been omitted from this filing. An exhibit to  the schedules and exhibits is contained in the Purchase and Sale Agreement  and the schedules and exhibits are available to the Securities and Exchange  Commission upon request), incorporated by reference from Exhibit 2.1 to  Current Report on Form 8-K filed on October 6, 2008.                                              |
| 2.2                |       | First Amendment to the Purchase  and Sale Agreement by and among Cano Petroleum, Inc., as Seller, and  Legacy Reserves Operating LP, as Buyer, and Pantwist, LLC, as the Company,  dated October 1, 2008 (The schedules and exhibits have been omitted from  this filing. An exhibit to the schedules and exhibits is contained in the  First Amendment to the Purchase and Sale Agreement and the schedules and  exhibits are available to the Securities and Exchange Commission upon  request), incorporated by reference from Exhibit 2.2 to Current Report  on Form 8-K filed on October 6, 2008. |
| 3.1                |       | Amendment to Amended and Restated  Bylaws, dated October 20, 2008, incorporated by reference from  Exhibit 3.1 to Current Report on Form 8-K filed on October 24,  2008.                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.1*              |       | Summary of 2009 Cash Incentive  Awards.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2               |       | Consulting Agreement dated  October 1, 2008 by and between Cano Petroleum, Inc. and Morris B.  Smith, incorporated by reference from Exhibit 10.1 to Current Report on  Form 8-K filed on October 6, 2008.                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.3*              |       | Amendment to Employment Agreement  of Phillip Feiner dated September 8, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.4*              |       | Prepayment Premium Letter dated  September 30, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |

 

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| 10.5* |   | Consent and Amendment No. 13  dated as of September 30, 2008 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. |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1* |   | Certification by Chief Executive  Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of  the Exchange Act, promulgated pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                             |
| 31.2* |   | Certification by Chief Financial  Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of  the Exchange Act, promulgated pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                             |
| 32.1* |   | Certification by Chief Executive  Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of  the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the  United States Code, promulgated pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                  |
| 32.2* |   | Certification by Chief Financial  Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of  the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the  United States Code, promulgated pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                  |

 

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*                    Filedherewith

 

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**SIGNATURES**

 

In accordance with the requirementsof the Exchange Act, the registrant caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
| **CANO PETROLEUM,  INC.**    |   |                                               |
|------------------------------|--------|----------------------------------------------------|
|                         |   |                                               |
| Date: November 10, 2008 | By:    | /s/ S. Jeffrey Johnson                             |
|                         |   | S. Jeffrey Johnson                                 |
|                         |   | Chief Executive Officer                            |
|                         |   |                                               |
|                         |   |                                               |
| Date: November 10, 2008 | By:    | /s/ Benjamin Daitch                                |
|                         |   | Benjamin Daitch                                    |
|                         |   | Senior Vice-President and Chief  Financial Officer |
|                         |   |                                               |
|                         |   |                                               |
| Date: November 10, 2008 | By:    | /s/ Michael J. Ricketts                            |
|                         |   | Michael J. Ricketts                                |
|                         |   | Vice-President and Principal  Accounting Officer   |

 

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