Exhibit 10.3


NONQUALIFIED STOCK OPTION AGREEMENT


CANO PETROLEUM, INC.

2005 LONG-TERM INCENTIVE PLAN


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


Morris B. Smith

(the “Participant”),


an option to
purchase shares of Common Stock (“Common Stock”) of the Company as follows:


On the date hereof, the
Company grants to the Participant an option (the “Option” or “Stock Option”) to
purchase Thirty-five Thousand (35,000) full shares (the “Optioned Shares”) of
Common Stock at an Option Price equal to $5.42 per share.  The Date of Grant of this Stock Option is
December 28, 2006.


The “Option Period” shall
commence on the Date of Grant and shall expire on the date immediately
preceding the tenth (10th)
anniversary of the Date of Grant.  The
Stock Option is a Nonqualified Stock Option. 
This Stock Option is intended to
comply with the provisions governing nonqualified stock options under Internal
Revenue Service Notice 2005-1 and the proposed Treasury Regulations issued
under Section 409A of the Code on September 29, 2005 in order to exempt this
Stock Option from application of Section 409A of the Code.


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


3.             Vesting; Time of Exercise.  Except as specifically provided in this
Agreement and subject to certain restrictions and conditions set forth in the
Plan, one-third (1/3) of the total Optioned Shares shall vest and that portion
of the Stock Option shall become exercisable on the first anniversary of the
Date of Grant, one-third (1/3) of the total Optioned Shares shall vest and that
portion of the Stock Option shall become exercisable on the second anniversary
of the Date of Grant, and one-third (1/3) of the total Optioned Shares shall
vest and that portion of the Stock Option shall become exercisable on the third
anniversary of the Date of Grant, provided the Participant is employed by (or,
if the Participant is a consultant or an Outside Director, is providing
services to) the Company or a Subsidiary on those dates.  In the event that a Change in Control occurs,
then immediately prior to the effective date of such Change in Control the
total Optioned Shares not previously vested shall thereupon immediately become
vested and this Option shall become fully exercisable if not previously so
exercisable.


4.             Term; Forfeiture.



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


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


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


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


iv.            5 p.m. on the date which is three
hundred sixty-five (365) days following the date of the Participant’s
Termination of Service for any reason not otherwise specified in this Section
4.a.; or


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


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


5.             Who May Exercise.  Subject to the terms and conditions set forth
in Sections 3 and 4 above, during the lifetime of the Participant, the
Stock Option may be exercised only by the Participant, or by the Participant’s
guardian or personal or legal representative. 
If the Participant’s Termination of Service is due to his death prior to
the date specified in Section 4.i. hereof, or the Participant dies prior
to the termination dates specified in Sections 4.i., ii., iii., or iv.
hereof, and the Participant has not exercised the Stock Option as to the
maximum number of vested Optioned Shares as set forth in Section 3
hereof as of the date of death, the following persons may exercise the
exercisable portion of the Stock Option on behalf of the Participant at any
time prior to the earliest of the dates specified in Section 4
hereof:  the personal representative of
his estate, or the person who acquired the right to exercise the Stock Option
by bequest or inheritance or by reason of the death of the Participant;
provided that the Stock Option shall remain subject to the other terms of this
Agreement, the Plan, and applicable laws, rules, and regulations.  Notwithstanding the foregoing sentence, by
delivering to the Company the prescribed form (see Appendix A), the Participant
may designate one or more beneficiaries and successor beneficiaries who may
exercise the exercisable portion of the Option on behalf of the Participant at
any time prior to the earliest of the dates specified in Section 4
hereof (provided that the Option shall remain subject to the other terms of
this Agreement and applicable laws, rules, and regulations) in the event (i) of
the Participant’s Termination of Service due to his death prior to the date
specified in Section 4.a.i. hereof, or 
(ii) the Participant dies prior to the termination dates specified in Sections
4.a.i., ii., iii., iv. or v. hereof, and the Participant has not exercised
the Option as to the maximum number of vested Optioned Shares as set forth in Section 3




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hereof as of the
date of death.  In the event the
Participant does not deliver to the Company a form designating one or more
beneficiaries, or no designated beneficiary survives the Participant, the
foregoing sentence shall not apply.


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


7.             Manner of Exercise.  Subject to such administrative regulations as
the Committee may from time to time adopt, the Stock Option may be exercised by
the delivery of written notice to the Committee setting forth the number of
shares of Common Stock with respect to which the Stock Option is to be
exercised, the date of exercise thereof (the “Exercise Date”) which shall be at least
three (3) days after giving such notice unless an earlier time shall have been
mutually agreed upon.  On the Exercise
Date, the Participant shall deliver to the Company consideration with a value
equal to the total Option Price of the shares to be purchased, payable as follows:  (a) cash, check, bank draft, or money order
payable to the order of the Company, (b) Common Stock (including Restricted
Stock owned by the Participant on the Exercise Date, valued at its Fair Market
Value on the Exercise Date, and which the Participant has not acquired from the
Company within six (6) months prior to the Exercise Date, (c) if the Optioned
Shares are Publicly Traded (as defined herein), by delivery (including by FAX)
to the Company or its designated agent of an executed irrevocable option
exercise form together with irrevocable instructions from the Participant to a
broker or dealer, reasonably acceptable to the Company, to sell certain of the
shares of Common Stock purchased upon exercise of the Stock Option or to pledge
such shares as collateral for a loan and promptly deliver to the Company the
amount of sale or loan proceeds necessary to pay such purchase price, and/or
(d) in any other form of valid consideration that is acceptable to the
Committee in its sole discretion.  In the event that shares of Restricted Stock
are tendered as consideration for the exercise of a Stock Option, a number of
shares of Common Stock issued upon the exercise of the Stock Option equal to
the number of shares of Restricted Stock used as consideration therefor shall
be subject to the same restrictions and provisions as the Restricted Stock so
tendered.  For purposes of this Section
7, the Common Stock shall be “Publicly Traded”
if the Common Stock subjects the Company to the periodic reporting
requirements of Sections 12(g) or 15(d) of the 1934 Act.


Upon
payment of all amounts due from the Participant, the Company shall cause
certificates for the Optioned Shares then being purchased to be delivered to
the Participant (or the person exercising the Participant’s Stock Option in the
event of his death) at its principal business office within ten (10) business
days after the Exercise Date. The obligation of the Company to deliver shares
of Common Stock shall, however, be subject to the condition that if at any time
the Company shall determine in its discretion that the listing, registration,
or qualification of the Stock Option or the Optioned Shares upon any securities
exchange or under any state or federal law, or the consent or approval of any
governmental regulatory body, is necessary as a condition of, or in connection
with, the Stock Option or the issuance or purchase of shares of Common Stock
thereunder, then the Stock Option may not be exercised in whole or in part
unless such listing, registration, qualification, consent, or approval shall
have been effected or obtained free of any conditions not reasonably acceptable
to the Committee.


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


8.             Nonassignability.  The Stock Option is not assignable or
transferable by the Participant except by will or by the laws of descent and
distribution.


9.             Rights as Stockholder.  The Participant will have no rights as a
stockholder with respect to any shares covered by the Stock Option until the
issuance of a certificate or certificates to the 



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Participant for
the Optioned Shares.  The Optioned Shares
shall be subject to the terms and conditions of this Agreement regarding such
Shares.  Except as otherwise provided in Section 10
hereof, no adjustment shall be made for dividends or other rights for which the
record date is prior to the issuance of such certificate or certificates.


10.           Adjustment of Number of Optioned
Shares and Related Matters.  The
number of shares of Common Stock covered by the Stock Option, and the Option
Prices thereof, shall be subject to adjustment in accordance with Articles
11 - 13 of the Plan.


11.           Nonqualified Stock Option.  The Stock Option shall not be treated as an
Incentive Stock Option.


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


13.           Proxies.  The Participant shall execute an irrevocable
proxy with respect to any shares of Restricted Stock authorizing the Board to
vote such shares on all issues until the expiration of the Restriction
Period.  Subject to the foregoing
provisions of this Section, the Participant may not grant a proxy to any
person, other than a revocable proxy not to exceed 30 days in duration granted
to another stockholder for the sole purpose of voting for directors of the
Company.


14.           Community
Property.  Each spouse individually
is bound by, and such spouse’s interest, if any, in any Optioned Shares is
subject to, the terms of this Agreement. 
Nothing in this Agreement shall create a community property interest
where none otherwise exists.


15.           Participant’s Representations.  Notwithstanding any of the provisions hereof,
the Participant hereby agrees that he will not exercise the Stock Option
granted hereby, and that the Company will not be obligated to issue any shares
to the Participant hereunder, if the exercise thereof or the issuance of such
shares shall constitute a violation by the Participant or the Company of any
provision of any law or regulation of any governmental authority.  Any determination in this connection by the
Company shall be final, binding, and conclusive.  The obligations of the Company and the rights
of the Participant are subject to all applicable laws, rules, and regulations.


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


17.           Participant’s Acknowledgments.  The Participant acknowledges receipt of a
copy of the Plan, which is annexed hereto, and represents that he or she is
familiar with the terms and provisions thereof, and hereby accepts this Option
subject to all the terms and provisions thereof. The Participant 



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hereby agrees to
accept as binding, conclusive, and final all decisions or interpretations of
the Committee or the Board, as appropriate, upon any questions arising under
the Plan or this Agreement.


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


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


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


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


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


23.           Parties Bound.  The terms, provisions, and agreements that
are contained in this Agreement shall apply to, be binding upon, and inure to
the benefit of the parties and their respective heirs, executors,
administrators, legal representatives, and permitted successors and assigns,
subject to the limitation on assignment expressly set forth herein. No person or entity shall be permitted to
acquire any Optioned Shares without first executing and delivering an agreement
in the form satisfactory to the Company making such person or entity subject to
the restrictions on transfer contained herein.


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



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


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


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


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


Cano
Petroleum, Inc.

801 Cherry Street

Suite 3200, Unit 25

Fort Worth, TX  76102

Attn:  Corporate Secretary


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


28.           Tax Requirements.  The Participant is hereby advised to consult
immediately with his or her own tax advisor regarding the tax consequences of
this Agreement.  The Company or, if
applicable, any Subsidiary (for purposes of this Section 28, the term “Company” shall be
deemed to include any applicable Subsidiary), shall have the right to deduct
from all amounts hereunder paid in cash or other form, any Federal, state,
local, or other taxes required by law to be withheld in connection with this
Award.  The Company may, in its sole
discretion, also require the Participant receiving shares of Common Stock
issued under the Plan to pay the Company the amount of any taxes that the
Company is required to withhold in connection with the Participant’s income arising
with respect to this Award.  Such
payments shall be required to be made when requested by the Company and may be
required to be made prior to the delivery of any certificate representing
shares of Common Stock.  Such payment may
be made (i) by the delivery of cash to the Company in an amount that equals or
exceeds (to avoid the issuance of fractional shares under (iii) below) the
required tax withholding obligations of the Company; (ii) if the Company, in
its sole discretion, so consents in writing, the actual delivery by the
exercising Participant to the Company of shares of Common Stock other than (A)
Restricted Stock, or (B) Common Stock that the Participant has not acquired from the
Company within six (6) months prior to the date of exercise, which shares so
delivered have an aggregate Fair Market Value that equals or exceeds (to avoid
the issuance of fractional shares under (iii) below) the required tax
withholding payment; (iii) if the Company, in its sole discretion, so consents
in writing, the Company’s withholding of a number of shares to be delivered
upon the exercise of the Stock Option other than shares that will constitute
Restricted Stock, which shares so withheld have an aggregate fair market value
that equals (but does not exceed) the required tax withholding payment; or (iv)
any combination of (i), (ii), or (iii). 
The Company may, in its sole discretion, withhold any such taxes from
any other cash remuneration otherwise paid by the Company to the Participant.


* * * * * * * *



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IN
WITNESS WHEREOF, the Company has caused this Agreement to be executed by its
duly authorized officer, and the Participant, to evidence his consent and
approval of all the terms hereof, has duly executed this Agreement, as of the
date specified in Section 1 hereof.


	
  

  	
   

  	
   

  	
  COMPANY:

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
  CANO PETROLEUM, INC.

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
  

  	
   

  	
   

  	
  By:

  	
  /s/ S. Jeffrey Johnson

  
	
   

  	
   

  	
   

  	
  Name:

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
   

  	
  Title:

  	
  Chairman and CEO

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
  PARTICIPANT:

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
  /s/ Morris B. Smith

  
	
   

  	
   

  	
   

  	
  Signature

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
  Name:

  	
  Morris B. Smith

  	
   

  
	
   

  	
   

  	
   

  	
  Address:

  	
  110 River Run Drive

  Azle, Texas  76020

  	
   

  
								



 



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APPENDIX
A


Beneficiary
Designation


To:                              Corporate
Secretary designated in the Cano Petroleum Inc. Nonqualified Stock Option
Agreement by and between Cano Petroleum Inc. and Morris B. Smith (the “Agreement”)


From:      Morris B. Smith


Pursuant
to Section 5 of the Agreement made as of December 28, 2006, I hereby designate
the following persons(s) as beneficiary(ies) who on my death who may exercise
the exercisable portion of the Option on my behalf pursuant to the Agreement:




	
  Primary
  Beneficiary Name:

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
  Secondary
  Beneficiary Name:

  	
   

  	
   

  
	
   

  	
   

  	
   

  
				






 


In
making the above designation, I reserve the right to revoke this beneficiary
designation or change the beneficiary(ies) designated at any time or times and
without the consent of any beneficiary.


This
beneficiary designation cancels and supersedes any beneficiary designation I
previously made with respect to this Agreement.




	
  Signed:

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
  Individual

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
  Date

  	
   

  	
   

  






 


 



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