**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

# **FORM 10-QSB**

# ** **

**(Mark One)**

 
| **ý** | ** ** | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30,  2005** |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                     |
| **o**      | ** ** | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF  THE EXCHANGE ACT**                                                                           |

 

**For thetransition period from               to               **

 

**Commissionfile number**

 

**CANO PETROLEUM, INC.**

(Exact name of smallbusiness issuer as specified in its charter)

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

 

**The Oil &Gas Commerce Building**

**309 West 7thStreet, Suite 1600**

**Fort Worth,TX 76102**

(Address of principalexecutive offices)

 

**(817) 698-0900**

(Issuer’s telephone number)

 

**NotApplicable**

(Former name, former addressand former fiscal year, if changed since last report)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Actduring 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 ý      No o

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  Yes o     No ý

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGSDURING THE PRECEDING FIVE YEARS**

 

Check whether the registrant filed all documents andreports required to be filed by Section 12, 13 or 15(d) of the ExchangeAct after the distribution of securities under a plan confirmed by acourt.  Yes o      No o

 

**APPLICABLEONLY TO CORPORATE ISSUERS**

 

State the number of shares outstanding of each ofthe issuer’s classes of common equity, as of the latest practicable date: 25,040,838 shares of common stock, $.0001 par value per share, as of November 8,2005.

 

Transitional Small Business Disclosure Format (Checkone): Yes o      No ý

 

 

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**PART I- FINANCIAL INFORMATION**

 

**Item 1. Financial Statements.**

 

**CANO PETROLEUM, INC.**

**CONSOLIDATED BALANCE SHEET**

**(Unaudited)**

 
| ** **                                                                                                                                                 | ** ** | **September 30,** | ** **     |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|----------------|
| ** **                                                                                                                                                 | ** ** | **2005**               | ** **     |
| ASSETS                                                                                                                                                     |       |                   |           |
| **Current  assets**                                                                                                                                        | ** ** | ** **             | ** **     |
| Cash and  cash equivalents                                                                                                                                 |       | $                      | 17,360,349     |   |
| Accounts  receivable                                                                                                                                       |       | 726,643                |           |
| Other  current assets                                                                                                                                      |       | 217,652                |           |
| Total  current assets                                                                                                                                      |       | 18,304,644             |           |
|                                                                                                                                                       |       |                   |           |
| **Oil and  gas properties,** successful efforts method                                                                                                     |       | 17,046,208             |           |
| Less  accumulated depletion and depreciation                                                                                                               |       | (586,556               | )              |
| Net oil and  gas properties                                                                                                                                |       | 16,459,652             |           |
|                                                                                                                                                       |       |                   |           |
| Fixed assets  and other, net                                                                                                                               |       | 753,139                |           |
| Goodwill                                                                                                                                                   |       | 101,166                |           |
| **TOTAL  ASSETS**                                                                                                                                          |       | **$**                  | **35,618,601** |   |
| ** **                                                                                                                                                 |       |                   |           |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                 |       |                   |           |
| **Current  liabilities**                                                                                                                                   | ** ** | ** **             | ** **     |
| Accounts  payable                                                                                                                                          |       | $                      | 911,557        |   |
| Oil and gas  sales payable                                                                                                                                 |       | 66,979                 |           |
| Current  portion of asset retirement obligations                                                                                                           |       | 18,729                 |           |
| Total  current liabilities                                                                                                                                 |       | 997,265                |           |
| **Long-term liabilities**                                                                                                                                  | ** ** | ** **             | ** **     |
| Asset  retirement obligations                                                                                                                              |       | 1,051,208              |           |
| Total  liabilities                                                                                                                                         |       | 2,048,473              |           |
| **Commitments  and contingencies (Note 8)**                                                                                                                | ** ** | ** **             | ** **     |
| **Stockholders’  equity**                                                                                                                             | ** ** | ** **             | ** **     |
| Common  stock, par value $.0001 per share; 50,000,000 authorized; 25,056,621 issued  and 25,040,838 outstanding; including 2,659,975 shares held in escrow |       | 2,506                  |           |
| Additional  paid-in capital                                                                                                                                |       | 44,430,570             |           |
| Accumulated  deficit                                                                                                                                       |       | (10,463,952            | )              |
| Treasury  stock, at cost; 15,783 shares held in escrow                                                                                                     |       | (7,102                 | )              |
| Deferred  compensation                                                                                                                                     |       | (391,894               | )              |
| Total  stockholders’ equity                                                                                                                           |       | 33,570,128             |           |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                       |       | **$**                  | **35,618,601** |   |

 

***See accompanyingnotes to these unaudited financial statements.***

 

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** **

**CANO PETROLEUM, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                           | ** ** | **September 30,** | ** ** |
| ** **                                                           | ** ** | **2005 **         | ** ** | **2004** | ** ** |
| **Operating  Revenues:**                                             | ** ** | ** **             | ** ** | ** ** | ** ** |
| Crude oil  and natural gas sales                                     |       | $                      | 1,945,959  |   | $ | 843,160 |   |
|                                                                 |       |                   |       |   |   |
| **Operating  Expenses:**                                             | ** ** | ** **             | ** ** | ** ** | ** ** |
| Lease  operating expenses                                            |       | 750,173                |       | 394,123 |   |
| Production  taxes                                                    |       | 109,672                |       | 58,921 |   |
| General and  administrative                                          |       | 1,227,291              |       | 661,566 |   |
| Deferred  compensation expense                                       |       | 149,625                |       | 290,532 |   |
| Accretion of  asset retirement obligations                           |       | 20,594                 |       | 5,050 |   |
| Depletion  and depreciation                                          |       | 146,789                |       | 103,454 |   |
| Total operating  expenses                                            |       | 2,404,144              |       | 1,513,646 |   |
|                                                                 |       |                   |       |   |   |
| **Loss  from operations**                                            |       | (458,185               | )          | (670,486 | ) |
|                                                                 |       |                   |       |   |   |
| Interest  income and deductions, net                                 |       | 228                    |       | 4,813 |   |
|                                                                 |       |                   |       |   |   |
| **Net loss**                                                         |       | (457,957               | )          | (665,673 | ) |
| ** **                                                           |       |                   |       |   |   |
| Preferred  stock discount                                            |       | —                 |       | 336,534 |   |
|                                                                 |       |                   |       |   |   |
| **Loss  applicable to common stock**                                 |       | $                      | (457,957   | ) | $ | (1,002,207 | ) |
| ** **                                                           |       |                   |       |   |   |
| **Net loss  per share - basic and diluted**                          |       | $                      | (0.03      | ) | $ | (0.10 | ) |
|                                                                 |       |                   |       |   |   |
| **Weighted  average common shares outstanding** - basic and  diluted |       | 18,014,597             |       | 10,482,204 |   |

 

***See accompanyingnotes to these unaudited financial statements.***

 

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**CANOPETROLEUM, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Three Months Ended September 30,** | ** **     |
|-----------------------------------------------------------------------|------------|-------------------------------------------|----------------|
| ** **                                                            | ** ** | **2005**                                  | ** **     | **2004** | ** ** |
| **Cash  flow from operating activities:**                             |       |                                      |           |   |   |
| Net loss                                                              |       | $                                         | (457,957       | ) | $ | (665,673 | ) |
| Adjustments  needed to reconcile to net cash flow used in operations: |       |                                      |           |   |   |
| Accretion of  asset retirement obligations                            |       | 20,594                                    |           | 5,050 |   |
| Depletion  and depreciation                                           |       | 146,789                                   |           | 103,454 |   |
| Deferred  compensation expense                                        |       | 149,625                                   |           | 290,532 |   |
| Stock based  compensation                                             |       | 26,058                                    |           | — |   |
|                                                                  |       |                                      |           |   |   |
| Changes in  assets and liabilities relating to operations:            |       |                                      |           |   |   |
| Accounts  receivable                                                  |       | (150,877                                  | )              | (710,983 | ) |
| Inventory                                                             |       | (143,412                                  | )              | — |   |
| Accounts  payable                                                     |       | (134,602                                  | )              | 595,818 |   |
| Accrued  liabilities                                                  |       | 126,226                                   |           | (12,567 | ) |
| Oil and gas  sales payable                                            |       | (72,619                                   | )              | 125,269 |   |
| Other  current assets                                                 |       | (39,701                                   | )              | (84,012 | ) |
|                                                                  |       |                                      |           |   |   |
| **Net cash  used in operations**                                      |       | **(529,876**                              | **)**          | **(353,112** | **)** |
|                                                                  |       |                                      |           |   |   |
| **Cash  flow from investing activities:**                             |       |                                      |           |   |   |
| Additions to  oil and gas properties                                  |       | (454,943                                  | )              | (373,082 | ) |
| Additions to  other fixed assets                                      |       | (261,774                                  | )              | (144,251 | ) |
| Cash  restricted for development activities                           |       | —                                    |           | 194,000 |   |
| Acquisition  of additional Davenport revenue interest                 |       | —                                    |           | (525,000 | ) |
| Acquisition  of Nowata                                                |       | —                                    |           | (2,512,610 | ) |
| Acquisition  of Ladder                                                |       | —                                    |           | (2,111,517 | ) |
| **Net cash  used in investing activities**                            |       | **(716,717**                              | **)**          | **(5,472,460** | **)** |
| ** **                                                            |       |                                      |           |   |   |
| **Cash  flow from financing activities:**                             |       |                                      |           |   |   |
| Proceeds  from issuance of preferred stock, net                       |       | —                                    |           | 4,385,841 |   |
| Proceeds  from issuance of common stock, net                          |       | 18,461,453                                |           | — |   |
| **Net cash  from financing activities**                               |       | **18,461,453**                            | ** **     | **4,385,841** | ** ** |
|                                                                  |       |                                      |           |   |   |
| Net decrease  in cash and cash equivalents                            |       | 17,214,860                                |           | (1,439,731 | ) |
|                                                                  |       |                                      |           |   |   |
| Cash and  cash equivalents at beginning of period                     |       | 145,489                                   |           | 1,575,279 |   |
|                                                                  |       |                                      |           |   |   |
| **Cash and  cash equivalents at end of period**                       |       | **$**                                     | **17,360,349** | ** ** | **$** | **135,548** | ** ** |
| ** **                                                            |       |                                      |           |   |   |
| **Supplemental  disclosure of noncash transactions:**                 |       |                                      |           |   |   |
| Amortization  of preferred stock discount                             |       | $                                         | —         |   | $ | 336,534 |   |

 

***See accompanyingnotes to these unaudited financial statements.***

 

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***CANO PETROLEUM, INC.***

 

**NOTES TOFINANCIAL STATEMENTS**

 

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

 

The interim consolidated financial statements of Cano Petroleum, Inc.are unaudited and contain all adjustments (consisting primarily of normalrecurring accruals) necessary for a fair statement of the results for theinterim periods presented.  Results for interim periods are notnecessarily indicative of results to be expected for a full year or for previouslyreported periods due in part to the volatility in prices for crude oil andnatural gas, the timing of acquisitions, product demand, market competition,interruption in production, and the success of waterflooding and enhanced oilrecovery techniques. You should read these consolidated interim financialstatements in conjunction with the audited consolidated financial statementsand notes thereto included in Cano’s Form 10-KSB dated June 30, 2005.

 

In preparing the accompanying financial statements, management has madecertain estimates and assumptions that affect reported amounts in the financialstatements and disclosures of contingencies. Actual results may differ fromthose estimates.  Significant assumptions are required in the valuation ofproved oil and gas reserves, which may affect the amount at which oil and gasproperties are recorded.  It is at least reasonably possible theseestimates could be revised in the near term, and these revisions could bematerial.

 

**2.****             ****COMMON STOCK FINANCINGS**

 

On September 14, 2005 and September 16, 2005, we receivedwritten commitments for two private placement sales of 2,603,864 shares and2,100,000 shares, respectively, of our common stock at a per share price equalto $4.14, which was the closing price on September 13, 2005 on theAmerican Stock Exchange.  The gross and net proceeds totaled approximately$19.5 million and $18.5 million, respectively. The transactions closed on or before September 30, 2005.

 

The amount of common shares issued and outstanding is summarized asfollows:

 

| Issued  shares as of June 30, 2005                |   | 20,352,757 |   |
|--------------------------------------------------------|--------|------------|--------|
| Shares  issued in private placement (above)            |   | 4,703,864  |   |
| Issued  shares as of September 30, 2005           |   | 25,056,621 |   |
| Management  shares returned to Treasury Stock (Note 4) |   | (15,783    | )      |
| Outstanding  shares as of September 30, 2005      |   | 25,040,838 |   |

 

**3.****             ****ASSET RETIREMENT OBLIGATION**

 

Our financial statements reflect the provisions of Statement ofFinancial Accounting Standards No. 143,*Accounting for Asset Retirement Obligations*.  Our assetretirement obligation (“ARO”) primarily represents the estimated present valueof the amount we will incur to plug, abandon and remediate our producingproperties at the end of their productive lives, in accordance with applicablestate laws.  We determine our ARO by calculating the present value of expectedcash flows related to the liability.  At September 30, 2005, ourliability for ARO was $1,069,937, of which $1,051,208 is considered long-term. Our asset retirement obligations are recorded as current or non-currentliabilities based on the estimated timing of the anticipated cash flows.

 

The following table describes the changes in our asset retirementobligations for the three months ended September 30, 2005:

 

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| Asset  retirement obligation at July 1, 2005       |   | $      | 1,051,453 |   |
|---------------------------------------------------------|--------|--------|-----------|--------|
| Accretion  expense                                      |   | 20,594 |      |
| Plugging  costs                                         |   | (2,110 | )         |
| Asset  retirement obligation at September 30, 2005 |   | $      | 1,069,937 |   |

 

**4.****             ****DEFERRED COMPENSATION**

 

As discussed in our Form 10-KSB dated June 30, 2005, pursuantto the terms of the Merger Agreement dated May 28, 2004, eight individuals(six current employees, one former employee and one director) were issued5,165,000 shares of common stock.  These shares were placed in escrow andwill vest to the individuals based on a combination of continued employment (“compensationshares”) and achieving certain performance goals during the two years followingthe merger (“performance shares”).  The compensation shares amounted to2,659,975 shares and the performance shares amounted to 2,505,025 shares. Any shares that are not released from escrow will be returned to TreasuryStock.

 

We accounted for these shares in accordance with the provisions ofStatement of Financial Accounting Standard (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*,and SFAS No. 148, *Accounting forStock-Based Compensation — Transition and Disclosure*.  At themerger date, we recognized $2,324,250 of “Deferred Compensation” and “AdditionalPaid-in Capital” in the Consolidated Balance Sheet.  The shares wererecorded based on the quoted market price at the time of the transaction andare being amortized to expense over the periods earned.  At September 30,2005, the balance of Deferred Compensation was $391,894, net of amortizationexpense.

 

As of September 30, 2005, shares returned to treasury totaled15,783 shares and are recorded as Treasury Stock, at cost.  On July 1,2005, the compensation shares totaling 2,505,025 shares were released fromescrow to three executive officers.  At September 30,2005, the total escrowed shares were 2,659,975, of which the outstanding commonshares totaled 2,644,192 and treasury shares totaled 15,783.

 

**5.****             ****STOCK OPTIONS**

 

As discussed in our Form 10-KSB dated June 30, 2005, the 2005Directors’ Stock Option Plan (“Plan”) became effective on April 1, 2005. On April 1, 2005, pursuant to the Plan, we granted stock options toour five non-employee directors to each purchase 25,000 shares of commonstock.  The options granted under the Plan totaled 125,000 shares. These options have an exercise price of $4.13 per share.  The options veston April 1, 2006, and expire on April 1, 2015.

 

On September 16, 2005, we granted stock options to James K.Teringo, Jr., our Vice President,General Counsel and Corporate Secretary to purchase 50,000 shares of commonstock.  These options have an exerciseprice of $3.98 per share.  The optionsvest on July 11, 2006, and expire on September 16, 2015.

 

Pursuant to SFAS No. 123 and SFAS No. 148, we have recorded acharge to general and administrative expenses of $26,058 for the estimated fairvalue of the options.

 

**6.****             ****NET LOSS PER COMMON SHARE**

 

Basic net income (loss) per common share is computed by dividing thenet income attributable to common shareholders by the weighted average numberof shares of common stock outstanding during the period.  Diluted netincome (loss) per common share is computed in the same manner, but also 

 

5

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considersthe effect of the stock options.  The stock options are not considered forthe three months ended September 30, 2005 as their effects would beanti-dilutive.

 

The weighted average shares used in the basic loss per common sharecomputations for the three months ended September 30, 2005 and 2004 were18,014,597 shares and 10,482,204 shares, respectively.  The shares at September 30,2005 and 2004 excluded contingently issuable shares of 2,659,975 and 5,165,000,respectively, as discussed in Note 4.

 

**7.****             ****RELATED PARTY TRANSACTIONS**

 

As discussed in our Form 10-KSB dated June 30, 2005,on March 29,2005, we entered into anagreement with Haddock Enterprises, LLC and Kenneth Q. Carlile (predecessor toCarlile Management, LLC) to explore the possibility of converting the SabineRoyalty Trust from a liquidating asset into a vehicle to acquire low riskassets.  Each of the three parties owns a one-third interest in the SabineProduction Operating, LLC.  Gerald W. Haddock is President of HaddockEnterprises, LLC and is a member of our Board of Directors.  As of September 30,2005, Cano had incurred approximately $260,000 pertaining to the joint venture,of which $220,000 occurred during the three months ended September 30,2005.  We use the equity method ofaccounting for our investment in the joint venture.  The losses through September 30, 2005have been insignificant.

 

**8.****             ****COMMITMENTS AND CONTINGENCIES**

 

***Litigation***

 

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

 

***Other***

 

To date, our expenditures to comply with environmental or safetyregulations have not been significant and are not expected to be significant inthe future. However, new regulations, enforcement policies, claims for damagesor other events could result in significant future costs.

 

**Item 2.  Management’sDiscussion and Analysis or Plan of Operation**

 

**Forward-Looking Statements**

 

The information in thisreport on Form 10-QSB contains forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995. This Actprovides a “safe harbor” for forward-looking statements to encourage companiesto provide prospective information about themselves provided they identifythese statements as forward looking and provide meaningful cautionarystatements identifying important factors that could cause actual results todiffer from the projected results. All statements other than statements ofhistorical fact made in this report are forward looking. In particular, thestatements herein regarding industry prospects and future results of operationsor financial position are forward-looking statements. Forward-lookingstatements reflect management’s current expectations and are inherentlyuncertain. Our actual results may differ significantly from management’sexpectations as a result of many factors, including, but not limited to, thevolatility in prices for crude oil and natural gas, the timing of acquisitions,product demand, market competition, interruption in production, and the successof waterflooding and enhanced oil recovery techniques.

 

You should read thefollowing discussion and analysis in conjunction with the consolidatedfinancial statements of Cano Petroleum, Inc. and subsidiaries and notesthereto, included herewith. This discussion should not be construed to implythat the results discussed herein will necessarily continue into 

 

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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.

 

**Overall Strategy**

 

We are a growing independentoil and gas company that intends to actively utilize secondary and enhanced oilrecovery (“EOR”) methods to increase production and reserves at our existingproperties and future acquisitions.  Our primary focus is crude oil andour target acquisitions are onshore U.S. properties.  Our focus ondomestic, mature oil fields eliminates exploration risks and logisticaluncertainties inherent in international operations.  We use secondarywaterflooding and EOR methods, such as surfactant-polymer flooding technology.

 

We believe significantgrowth opportunities exist primarily because the major energy companies andlarge independents continue to focus their attention and resources toward theexploration and production of large fields.  In the past several years,the major companies have been divesting themselves of their mature, smaller oilfields.  During recent years, the energy industry has predominatelyfocused on natural gas exploration and production, and has been significantlyless focused on crude oil.  The recent economics of the oil and gas markethave improved as prices have risen substantially.  These conditionsprovide ample opportunities for smaller independent companies to acquire andexploit mature U.S. oilfields.  Ouremphasis on EOR methods positions us in a unique niche segment in the oil andgas industry.  Our acquisition targetsare proven, mature oil fields that possess significant proved reserves, as wellas a high ratio of probable reserves.  Weexpect to encounter increased competition for such properties in the future.

 

**Liquidity and Capital Resources**

 

We intend to finance futureacquisitions of oil and gas properties, field development projects andoperating activities with a combination of issuances of equity, debt financing,access to capital markets, and cash flow from operations.  We cannotguarantee that any additional equity or debt financing will be available insufficient amounts or on acceptable terms when needed.  If such financingis not available in sufficient amounts or on acceptable terms, our results ofoperations and financial condition may be adversely affected.  Inaddition, equity financing may result in dilution to existing stockholders andmay involve securities that have rights, preferences, or privileges that aresenior to our common stock, and any debt financing obtained must be repaidregardless of whether or not we generate profits or cash flows from ourbusiness activities.

 

***Financing and Investing Activities***

 

As discussed in Note 2 tothe financial statements, we received net proceeds of $18.5 million from theissuance of 4,703,864 shares of common stock during September 2005.  Shares of common stock were sold at a pershare price equal to $4.14, which was the closing price on September 13,2005 on the American Stock Exchange.  The net proceeds of the issuancewill be used for general corporate purposes, capital expenditures and workingcapital.  At September 30, 2005, our cash balance was $17.4million.  Based on our current cashresources and other current assets, management believes we have sufficientliquidity to fund operations for the next twelve months.

 

Energy lenders typicallyloan to oil and gas companies based on the value of the proved producing reserves,defined as reserves that can be reasonably expected to be recovered fromexisting wells with existing equipment and operating methods from knownreservoirs under existing economic and operating conditions.  We intend toseek debt financing secured by our proved producing reserves to provide anadditional source of cash to fund our operating activities, capitalexpenditures and acquisitions.

 

Based on reserve reportsprepared by independent petroleum engineers dated July 1, 2005, our totalproved reserves are summarized as follows:

 

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| ** **                                               | ** ** | **Nowata** | ** ** | **Rich Valley** | ** ** | **Davenport** | ** ** | **Desdemona** | ** ** | **Total** | ** ** |
|----------------------------------------------------------|------------|------------|------------|-----------------|------------|---------------|------------|---------------|------------|-----------|------------|
| **Proved**                                               |       |       |       |            |       |          |       |          |       |      |       |
| Oil - Mbbls                                              |       | 1,492      |       | 299             |       | 478           |       | 786           |       | 3,055     |       |
| Gas - Mmcf                                               |       | 268        |       | 2,888           |       | 34            |       | 7,198         |       | 10,388    |       |
|                                                     |       |       |       |            |       |          |       |          |       |      |       |
| **Proved Barrels of Equivalent  Oil (“MBOE”)** | ** ** | **1,537**  | ** ** | **780**         | ** ** | **484**       | ** ** | **1,986**     | ** ** | **4,787** | ** ** |
| ** **                                               |       |       |       |            |       |          |       |          |       |      |       |
| **Proved Producing (MBOE)**                              | ** ** | **1,537**  | ** ** | **587**         | ** ** | **127**       | ** ** | **348**       | ** ** | **2,599** | ** ** |

 

***Capital Spending Plan for Fiscal Year 2006***

 

Our capital spending planfor our remaining fiscal year ending June 30, 2006, excluding potentialacquisitions, is projected to be $13.6 million to implement developmentalprojects at our existing fields to increase reserves and production as follows:

 

*DesdemonaField.*  Thisfield has not been previously waterflooded.  We began pilot waterfloodoperations in May 2005 and expect an initial response in nine to twelvemonths.  If the pilot waterfloods are successful, we intend to beginexpanding the waterflood to the entire field in 2006.  This field also hasmineral rights to the Barnett Shale.  We intend to sell these land rightsand focus on our core expertise — secondary and enhanced oil recovery.

 

*NowataField*.  Thisfield is currently being waterflooded.  We intend to increase productionand reserves by applying a chemical treatment known as surfactant-polymer floodingtechnology.  We are continuing to optimize the surfactant-polymer chemistryin the laboratory and intend to begin implementing a surfactant-polymer pilotduring the next three to six months.

 

*DavenportField*.  Thisfield is currently being waterflooded.  We intend to evaluate this fieldfor surfactant-polymer flooding technology.  This evaluation, coupled withthe knowledge gained from the Nowata pilot, is expected to enhance this field’svalue as a surfactant-polymer candidate.

 

*RichValley Field*. We intend to drill seven infill development wells and conduct an evaluation forwaterflood potential.

 

***Operating Activities***

 

For the three months ended September 30,2005 and 2004, net cash used in operating activities was $529,876 and $353,112,respectively.  We are seeking to improve cash flow from operatingactivities through operational improvements at our existing properties andfuture acquisitions.  The increased cash flow from field operations may beoffset, in part, by increased general and administrative costs to support ourexpanding operations.

 

**Results of Operations**

 

***Overall***

 

For the quarter ended September 30,2005 (“current quarter”), we had a loss applicable to common stock of $457,957,which is an improvement of $544,250 as compared to the $1,002,207 lossapplicable to common stock incurred for the quarter ended September 30,2004 (“prior year quarter”).  Factorsthat contributed to the $544,250 improvement are higher income from oil and gasoperations of $0.6 million, reduced preferred stock discount of $0.3 millionand lower amortization of deferred compensation expense of $0.2 million.  Partially offsetting these positive factorswere higher general & administrative expenses of $0.6 million

 

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Income from oil and gasoperations consists of operating revenues less lease operating expenses,production taxes, accretion of asset retirement obligations, and depletion anddepreciation.  The current quarterincludes a full three months of operations from our four fields – Nowata, RichValley, Davenport and Desdemona.  Theprior year quarter only includes one month of Nowata operations and nooperating effects from the Desdemona field. This is the primary reason that income from oil and gas operations hasincreased significantly when the current quarter is compared to the prior yearquarter.

 

The reduced preferred stockdiscount amounting to $0.3 million occurred in the prior year quarter and wasattributable to certain issuances of preferred stock during the prior yearquarter.  Since we did not issuepreferred stock during the current quarter, there is no preferred stockdiscount in the current quarter.

 

***OperatingRevenues***

 

The table below summarizesour operating revenues for the current and prior year quarters.

 
| ** **          | ** ** | **Three Months Ended September 30,** | ** ** | **Increase** | ** ** |
|---------------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **          | ** ** | **2005**                                  | ** ** | **2004**     | ** ** | **(Decrease)** | ** ** |
| Operating  Revenues |       | $                                         | 1,945,959  |         | $          | 843,160 |   | $ | 1,102,799 |   |
|                |       |                                      |       |         |       |   |   |
| Sales               |       |                                      |       |         |       |   |   |
| - Oil (MBbls)       |       | 28                                        |       | 13           |       | 15 |   |
| - Gas (MMcf)        |       | 42                                        |       | 44           |       | (2 | ) |
| - Total  (MBOE)     |       | 35                                        |       | 20           |       | 15 |   |
|                |       |                                      |       |         |       |   |   |
| Average  Price      |       |                                      |       |         |       |   |   |
| - Oil ($/  Bbl)     |       | $                                         | 60.36      |         | $          | 44.29 |   | $ | 16.07 |   |
| - Gas ($/  Mcf)     |       | $                                         | 6.22       |         | $          | 5.86 |   | $ | 0.36 |   |

 

The current quarteroperating revenues of $1.9 million represent an improvement of $1.1 million ascompared to the prior year quarter of $0.8 million.  The $1.1 million improvement is attributableto the higher prices received for oil and gas sales, and increased oil sales asthe current quarter includes a full three months of operations from our fourfields, as previously discussed under “Results of Operations - Overall.”  The average price we received for crude oilsales is generally at or above market prices. The average price we receive for natural gas sales is approximately themarket price less transportation and marketing expenses.

 

***Operating Expenses***

 

For the current quarter, ourtotal operating expenses were $2.4 million, or $0.9 million higher than theprior year quarter of $1.5 million.  The$0.9 million increase is primarily attributed to higher lease operatingexpenses (“LOE”) of $0.4 million, increased production taxes from higher salesof $0.1 million and higher general & administrative expenses of $0.6million, partially offset by lower deferred compensation expense of $0.2million.

 

Our LOE consists of costs ofproducing crude oil and natural gas such as labor, supplies, repairs,maintenance, and utilities.  The $0.4 million increase resulted from thecurrent quarter including a full three months of operations from our fourfields, as previously discussed under “Results of Operations - Overall.”  For the current quarter, the LOE per BOE was$21.56 as compared to $19.38 per LOE for the prior year quarter.  Thecurrent quarter amount of $21.56 per BOE is an improvement as compared to theLOE per BOE of $22.88 that we incurred for the twelve month period ended June 30,2005.  We generally incur a high amountof LOE because we focus on long term cost improvement of operations at allfields.  Since our acquisitions are mature fields, our initial focus is toevaluate the existing operations and make the necessary operationalimprovements to improve operating efficiency.  Based on management’s pastexperience, it generally requires six to twelve months to fully analyze theacquired field and spend the necessary funds to improve the field operations tomeet our operational standards.   We expect these expenditures should lead toincreased operational efficiency and reduced operating expenses in futureperiods.

 

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Our general andadministrative expenses consist of support services for our operatingactivities and investor relations costs. The $0.6 million increase is primarily due to increased employeestaffing ($0.2 million), higher legal fees to comply with regulatoryrequirements ($0.1 million), incentive payments to certain employees ($0.1million), higher travel costs ($0.1 million) and increased insurance costs($0.1 million).

 

**Off Balance Sheet Arrangements**

 

We do not have any offbalance sheet arrangements that have or are reasonably likely to have a currentor future effect on our financial condition, changes in our financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources.

 

**Item 3.  Controls andProcedures.**

 

As of the end of the periodcovered by this report, we conducted an evaluation, under the supervision andwith the participation of our chief executive officer and chief financialofficer of our disclosure controls and procedures (as defined in Rule 13a-15(e) andRule 15d-15(e) of the Exchange Act). Based upon this evaluation, ourchief executive officer and chief financial officer concluded that ourdisclosure controls and procedures are effective to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is: (1) accumulatedand communicated to our management, including our chief executive officer andchief financial officer, as appropriate to allow timely decisions regardingrequired disclosure; and (2) recorded,processed, summarized and reported, within the time periods specified in theCommission’s rules and forms.  There was no change in our internalcontrols or in other factors that could affect these controls during our lastfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

**PART II– OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

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

 

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

 

All the unregistered sales of equity securitiesduring the third quarter were reflected in the Current Reports on Form 8-Kthat were filed with the Securities and Exchange Commission on September 20,2005 and October 5, 2005.

 

**Item 3.  Defaults Upon SeniorSecurities.**

 

There has been no materialdefault in the payment of principal, interest, a sinking or purchase fundinstallment, or any other material default not cured within 30 days, withrespect to any indebtedness exceeding five percent of our total assets. There also is no material arrearage in the payment of dividends or any othermaterial delinquency not cured within 30 days, with respect to any class ofpreferred stock which is registered or which ranks prior to any class of our registeredsecurities, or with respect to any class of preferred stock of any significantsubsidiary.

 

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**Item 4.  Submission of Mattersto a Vote of Security Holders.**

 

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

 

**Item 5.  Other Information.**

 

None.

 

**Item 6.  Exhibits.**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                               |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and Howard Hughes Medical  Institute, incorporated by reference to Form 8-K filed on September 22,  2005.                                            |
| 10.2                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and The Robert Wood Johnson  Foundation, incorporated by reference to Form 8-K filed on September 22,  2005.                                         |
| 10.3                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and Laborers’ District Council  and Contractors’ of Ohio Pension Fund, incorporated by reference to Form 8-K  filed on September 22, 2005. |
| 10.4                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and Ohio Carpenters’ Pension  Fund, incorporated by reference to Form 8-K filed on September 22,  2005.                                         |
| 10.5                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and New York Nurses Association  Pension Plan, incorporated by reference to Form 8-K filed on September 22,  2005.                                   |
| 10.6                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and Public Sector Pension  Investment Board, incorporated by reference to Form 8-K filed on September 22,  2005.                                     |
| 10.7                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and Spindrift Investors  (Bermuda) L.P., incorporated by reference to Form 8-K filed on September 22,  2005.                                         |
| 10.8                |       | Subscription Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and Spindrift Partners, L.P.,  incorporated by reference to Form 8-K filed on September 22, 2005.                                                    |
| 10.9+               |       | Employment Agreement dated as of July 11,  2005 by and between Cano Petroleum, Inc. and James K. Teringo, Jr.  incorporated by reference to Form 8-K filed on September 22, 2005.                                                    |
| 10.10+              |       | Stock Option Agreement dated September 16,  2005 by and between Cano Petroleum, Inc. and James K. Teringo, Jr.  incorporated by reference to Form 8-K filed on September 22, 2005.                                                   |
| 10.11               |       | Subscription Agreement dated September 14,  2005 by and between Cano Petroleum, Inc. and Touradji Global Resources  Master Fund, Ltd., incorporated by reference to Form 8-K filed on September 20,  2005.                                |
| 10.12               |       | Subscription Agreement dated September 14,  2005 by and between Cano Petroleum, Inc. and Renaissance US Growth  Investment Trust PLC, incorporated by reference to Form 8-K filed on September 20,  2005.                                 |
| 10.13               |       | Subscription Agreement dated September 14,  2005 by and between Cano Petroleum, Inc. and BFS US Special  Opportunities Trust PLC, incorporated by reference to Form 8-K filed on September 20,  2005.                                     |
| 10.14               |       | Subscription Agreement dated September 14,  2005 by and between Cano Petroleum, Inc. and Crestview Capital Master,  LLC, incorporated by reference to Form 8-K filed on September 20,  2005.                                              |
| 10.15+              |       | Summary Sheet for Salary of James K. Teringo, Jr.,  incorporated by reference to Form 8-K filed on August 9, 2005.                                                                                                                             |
| 10.16               |       | Sabine Production Partners Transition Summary,  incorporated by reference to Form 8-K                                                                                                                                                                    |

 

11

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|   |   | filed on August 9, 2005.                                                                                                                                                                                                                                                            |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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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*                 Filed herewith

+                 Management contract or compensatory plan, contract or arrangement

 

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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|   |                  | **CANO PETROLEUM, INC.** |
|--------|-----------------------|--------------------------|
|   |                  |                     |   |
| Dated: | November 9, 2005 | By:                      | /s/ S. Jeffrey Johnson |
|   |                  |                     | S. Jeffrey Johnson |
|   |                  |                     | Chief Executive Officer |
|   |                  |                     |   |
| Dated: | November 9, 2005 | By:                      | /s/ Michael J. Ricketts |
|   |                  |                     | Michael J. Ricketts |
|   |                  |                     | Chief Financial Officer and |
|   |                  |                     | Principal Accounting Officer |

 

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