**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

----

 

**FORM10-Q**

**x**** QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF**

**THESECURITIES EXCHANGE ACT OF 1934**

 

**FORTHE QUARTERLY PERIOD ENDED September 30, 2006**

**OR**

o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THESECURITIES EXCHANGE ACT OF 1934**

 

**FORTHE TRANSITION PERIOD FROM                TO**

**Commissionfile number:  000-51120**

**HilandPartners, LP**

(Exact name of Registrantas specified in its charter)

** **

| **DELAWARE**                              |   | **71-0972724**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer     |
| incorporation or  organization)           |   | Identification  No.) |
|                                      |   |                 |
| **205  West Maple, Suite 1100**           |   | ** **           |
| **Enid,  Oklahoma**                       |   | **73701**            |
| (Address of  principal executive offices) |   | (Zip code)           |

 

Registrant’stelephone number including area code**(580)242-6040**

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days Yes x No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer x |
|--------------------------------|--------|--------------------------|--------|------------------------------|

 

Indicate by a check markwhether the registrant is a shell company (as defined in rule 12b-2 of theExchange Act). Yes o No x

The number of theregistrant’s outstanding equity units at November 6, 2006 was 5,175,247 commonunits, 4,080,000 subordinated units and a 2% general partnership interest.

 

 

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**HILAND PARTNERS,LPINDEX**
| **PART I. FINANCIAL INFORMATION**                                                                    | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------|------------|
| Item 1.  Financial Statements (Unaudited, except December 31, 2005 Balance Sheet)                    |       |       |       |
| Consolidated Balance  Sheets                                                                         |       |       |       |
| Consolidated  Statements of Operations                                                               |       |       |       |
| Consolidated  Statements of Cash Flows                                                               |       |       |       |
| Consolidated  Statement of Changes in Owners’ Equity and Comprehensive Income                   |       |       |       |
| Condensed  Notes to Consolidated Financial Statements                                                |       |       |       |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |       |       |       |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risks                                 |       |       |       |
| Item 4. Controls and  Procedures                                                                     |       |       |       |
| **PART II. OTHER  INFORMATION**                                                                      | ** ** | ** ** | ** ** |
| Item 1. Legal Proceedings                                                                            |       |       |       |
| Item 1A. Risk Factors                                                                                |       |       |       |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                 |       |       |       |
| Item 3.  Defaults Upon Senior Securities                                                             |       |       |       |
| Item 4.  Submission of Matters to a Vote of Security Holders                                         |       |       |       |
| Item 5. Other Information                                                                            |       |       |       |
| Item 6. Exhibits                                                                                     |       |       |       |
| SIGNATURES                                                                                           |       |       |       |
| Certification of  CEO under Section 302                                                              |       |       |       |
| Certification of  CFO under Section 302                                                              |       |       |       |
| Certification of  CEO under Section 906                                                              |       |       |       |
| Certification of CFO  under Section 906                                                              |       |       |       |

 

5

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** **

**HILAND PARTNERS,LPConsolidated Balance Sheets**
| ** **                                                                                                                                      | ** ** | **September 30,**                                  | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                      | ** ** | **2006**                                                | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                      | ** ** | **(unaudited)**                                         | ** ** | ** **            | ** ** |
| ** **                                                                                                                                      | ** ** | **(in thousands,  except unit amounts)** | ** ** |
| **ASSETS**                                                                                                                                      | ** ** | ** **                                              |       |                  |       |
| **Current assets:**                                                                                                                             |       |                                                    |       |                  |       |
| Cash and cash  equivalents                                                                                                                      |       | $                                                       | 9,237      |                  | $          | 6,187 |   |
| Accounts receivable:                                                                                                                            |       |                                                    |       |                  |       |
| Trade                                                                                                                                           |       | 17,836                                                  |       | 21,893                |       |
| Affiliates                                                                                                                                      |       | 1,079                                                   |       | 1,523                 |       |
|                                                                                                                                            |       | 18,915                                                  |       | 23,416                |       |
| Fair value of  derivative assets                                                                                                                |       | 4,322                                                   |       | 868                   |       |
| Other current assets                                                                                                                            |       | 337                                                     |       | 395                   |       |
| Total current assets                                                                                                                            |       | 32,811                                                  |       | 30,866                |       |
|                                                                                                                                            |       |                                                    |       |                  |       |
| Property and equipment,  net                                                                                                                    |       | 291,513                                                 |       | 120,715               |       |
| Intangibles, net                                                                                                                                |       |                                                    |       | 41,179                |       |
| Fair value of  derivative assets                                                                                                                |       | 2,549                                                   |       | 181                   |       |
| Other assets, net                                                                                                                               |       | 1,782                                                   |       | 1,028                 |       |
|                                                                                                                                            |       |                                                    |       |                  |       |
| **Total assets**                                                                                                                                |       | $                                                       | 328,655    |                  | $          | 193,969 |   |
|                                                                                                                                            |       |                                                    |       |                  |       |
| **LIABILITIES AND OWNERS’ EQUITY**                                                                                                         | ** ** | ** **                                              | ** ** | ** **            | ** ** |
| **Current liabilities:**                                                                                                                        |       |                                                    |       |                  |       |
| Accounts payable                                                                                                                                |       | $                                                       | 12,902     |                  | $          | 13,324 |   |
| Accounts  payable-affiliates                                                                                                                    |       | 4,667                                                   |       | 6,122                 |       |
| Fair value of  derivative liabilities                                                                                                           |       | 1,671                                                   |       | —                |       |
| Accrued liabilities                                                                                                                             |       | 1,369                                                   |       | 1,126                 |       |
| Total current  liabilities                                                                                                                      |       | 20,609                                                  |       | 20,572                |       |
|                                                                                                                                            |       |                                                    |       |                  |       |
| Commitments and  contingencies (Note 7)                                                                                                         |       |                                                    |       |                  |       |
| Long-term debt                                                                                                                                  |       | 134,064                                                 |       | 33,784                |       |
| Fair value of  derivative liabilities                                                                                                           |       | 557                                                     |       | —                |       |
| Asset retirement  obligation                                                                                                                    |       | 2,177                                                   |       | 1,024                 |       |
|                                                                                                                                            |       |                                                    |       |                  |       |
| **Owners’ equity**                                                                                                                         |       |                                                    |       |                  |       |
| Limited partners’  interest:                                                                                                               |       |                                                    |       |                  |       |
| Common  unitholders (5,175,247 and 4,358,000 units issued and outstanding at  September 30, 2006 and December 31, 2005, respectively) |       | 141,535                                                 |       | 110,027               |       |
| Subordinated  unitholders (4,080,000 units issued and outstanding at September 30,  2006 and December 31, 2005)                       |       | 21,554                                                  |       | 25,126                |       |
| General partner  interest                                                                                                                       |       | 3,649                                                   |       | 2,676                 |       |
| Unearned compensation                                                                                                                           |       | —                                                  |       | (289                  | )          |
| Accumulated other  comprehensive income                                                                                                         |       | 4,510                                                   |       | 1,049                 |       |
| **Total owners’ equity**                                                                                                                   |       | 171,248                                                 |       | 138,589               |       |
|                                                                                                                                            |       |                                                    |       |                  |       |
| **Total liabilities and owners’ equity**                                                                                                   |       | $                                                       | 328,655    |                  | $          | 193,969 |   |

 

The accompanying notesare an integral part of these financial statements.

6

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** **

**HILAND PARTNERS,LPConsolidated Statements of OperationsFor the Three and Nine Months Ended (Unaudited)**
| ** **                                                                    | ** ** | **Three Months Ended**                                     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                    | ** ** | **September 30,**                                               | ** ** | **September 30,**          | ** ** |
| ** **                                                                    | ** ** | **2006**                                                             | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                    | ** ** | **(in thousands, except per unit amounts)** | ** ** |
| **Revenues:**                                                                 |       |                                                                 |       |                            |       |   |   |   |   |
| Midstream  operations                                                         |       |                                                                 |       |                            |       |   |   |   |   |
| Third parties                                                                 |       | $                                                                    | 55,137     |                            | $          | 39,608 |   | $ | 156,606 |   | $ | 91,780 |   |
| Affiliates                                                                    |       | 925                                                                  |       | 1,112                           |       | 3,194 |   | 3,514 |   |
| Compression  services, affiliate                                              |       | 1,205                                                                |       | 1,205                           |       | 3,615 |   | 3,012 |   |
| Total revenues                                                                |       | 57,267                                                               |       | 41,925                          |       | 163,415 |   | 98,306 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Operating  costs and expenses:**                                            |       |                                                                 |       |                            |       |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below)              |       | 26,480                                                               |       | 21,713                          |       | 78,389 |   | 50,750 |   |
| Midstream  purchases -affiliate (exclusive of items shown separately below)   |       | 13,129                                                               |       | 11,600                          |       | 39,576 |   | 26,798 |   |
| Operations and  maintenance                                                   |       | 4,569                                                                |       | 1,897                           |       | 11,140 |   | 5,083 |   |
| Depreciation,  amortization and accretion                                     |       | 6,175                                                                |       | 2,912                           |       | 15,811 |   | 6,924 |   |
| General and  administrative expenses                                          |       | 1,375                                                                |       | 521                             |       | 3,653 |   | 1,539 |   |
| Total operating  costs and expenses                                           |       | 51,728                                                               |       | 38,643                          |       | 148,569 |   | 91,094 |   |
| Operating income                                                              |       | 5,539                                                                |       | 3,282                           |       | 14,846 |   | 7,212 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Other  income (expense):**                                                  |       |                                                                 |       |                            |       |   |   |   |   |
| Interest and  other income                                                    |       | 68                                                                   |       | 70                              |       | 222 |   | 112 |   |
| Amortization of  deferred loan costs                                          |       | (86                                                                  | )          | (83                             | )          | (319 | ) | (360 | ) |
| Interest expense                                                              |       | (1,783                                                               | )          | (585                            | )          | (3,643 | ) | (766 | ) |
| Other income  (expense), net                                                  |       | (1,801                                                               | )          | (598                            | )          | (3,740 | ) | (1,014 | ) |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Net  income**                                                               |       | 3,738                                                                |       | 2,684                           |       | 11,106 |   | 6,198 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| Less income  attributable to predecessor                                      |       | —                                                               |       | —                          |       | — |   | 493 |   |
| Less general  partner interest in net income                                  |       | 712                                                                  |       | 67                              |       | 1,589 |   | 128 |   |
| **Limited  partners’ interest in net income**                            |       | $                                                                    | 3,026      |                            | $          | 2,617 |   | $ | 9,517 |   | $ | 5,577 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Net  income per limited partners’ unit — basic**                  |       | $                                                                    | 0.33       |                            | $          | 0.38 |   | $ | 1.07 |   | $ | 0.82 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Net  income per limited partners’ unit — diluted**                |       | $                                                                    | 0.33       |                            | $          | 0.38 |   | $ | 1.07 |   | $ | 0.82 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Weighted  average limited partners’ units outstanding — basic**   |       | 9,237                                                                |       | 6,800                           |       | 8,866 |   | 6,800 |   |
|                                                                          |       |                                                                 |       |                            |       |   |   |   |   |
| **Weighted average limited  partners’ units outstanding — diluted** |       | 9,286                                                                |       | 6,844                           |       | 8,912 |   | 6,830 |   |

 

The accompanying notesare an integral part of these financial statements.

7

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** **

**HILAND PARTNERS,LPConsolidated Statements of Cash FlowsFor the Nine Months Ended (Unaudited)**
| ** **                                                                         | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **2006**                | ** ** | **2005**               | ** ** |
| ** **                                                                         | ** ** | **(in thousands)** | ** ** |
| **Cash  flows from operating activities:**                                         |       |                    |       |                   |       |
| Net income                                                                         |       | $                       | 11,106     |                   | $          | 6,198 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                    |       |                   |       |
| Depreciation and  amortization                                                     |       | 15,763                  |       | 6,898                  |       |
| Accretion of  asset retirement obligation                                          |       | 47                      |       | 26                     |       |
| Amortization of  deferred loan cost                                                |       | 319                     |       | 360                    |       |
| Gain on hedge  ineffectiveness                                                     |       | (133                    | )          | —                 |       |
| Unit based  compensation                                                           |       | 338                     |       | —                 |       |
| (Increase)  decrease in current assets, net of acquisition effects:                |       |                    |       |                   |       |
| Accounts  receivable                                                               |       | 4,057                   |       | (14,413                | )          |
| Accounts  receivable — affiliates                                             |       | 444                     |       | (153                   | )          |
| Other current  assets                                                              |       | 60                      |       | (163                   | )          |
| Increase  (decrease) in current liabilities, net of acquisition effects:           |       |                    |       |                   |       |
| Accounts payable                                                                   |       | (422                    | )          | (938                   | )          |
| Accounts  payable-affiliates                                                       |       | (1,455                  | )          | 2,658                  |       |
| Accrued  liabilities                                                               |       | 243                     |       | 427                    |       |
| Increase in  other assets                                                          |       | (144                    | )          | —                 |       |
| **Net  cash provided by operating activities**                                     |       | 30,223                  |       | 900                    |       |
|                                                                               |       |                    |       |                   |       |
| **Cash  flows from investing activities:**                                         |       |                    |       |                   |       |
| Additions to  property and equipment                                               |       | (47,989                 | )          | (2,770                 | )          |
| Payments for  Kinta Area assets acquired                                           |       | (96,400                 | )          | —                 |       |
| Acquisition of  net assets of Hiland Partners, LLC, less cash received             |       | —                  |       | (62,440                | )          |
| Proceeds from  disposals of property and equipment                                 |       | 111                     |       | —                 |       |
| **Net  cash used in investing activities**                                         |       | (144,278                | )          | (65,210                | )          |
|                                                                               |       |                    |       |                   |       |
| **Cash  flows from financing activities:**                                         |       |                    |       |                   |       |
| Proceeds from  initial public offering — net                                  |       | —                  |       | 48,128                 |       |
| Redemption of  common units from organizers                                        |       | —                  |       | (6,278                 | )          |
| Distributions to  organizers                                                       |       | —                  |       | (3,851                 | )          |
| Cash not  contributed by organizers                                                |       | —                  |       | (869                   | )          |
| Payment of  initial public offering costs                                          |       | —                  |       | (2,249                 | )          |
| Proceeds from  long-term borrowings                                                |       | 100,280                 |       | 93,700                 |       |
| Payments on long-term  borrowings                                                  |       | —                  |       | (23,951                | )          |
| Debt issuance  costs                                                               |       | (929                    | )          | (1,189                 | )          |
| Common units  issued to our general partner                                        |       | 35,000                  |       | —                 |       |
| Contribution by  our general partner for issuance of restricted common units       |       | 7                       |       | 6                      |       |
| Proceeds from  unit option exercise                                                |       | 1,116                   |       | —                 |       |
| Cash  distribution to controlling member for net assets of Hiland Partners, LLC    |       | —                  |       | (27,768                | )          |
| Cash  distribution to unitholders                                                  |       | (18,369                 | )          | (4,770                 | )          |
| **Net  cash provided by financing activities**                                     |       | 117,105                 |       | 70,909                 |       |
|                                                                               |       |                    |       |                   |       |
| Increase for the  period                                                           |       | 3,050                   |       | 6,599                  |       |
| Beginning of  period                                                               |       | 6,187                   |       | 217                    |       |
| **End of  period**                                                                 |       | $                       | 9,237      |                   | $          | 6,816 |   |
|                                                                               |       |                    |       |                   |       |
| Supplementary  information                                                         |       |                    |       |                   |       |
| Cash paid for interest,  net of amounts capitalized                                |       | $                       | 3,464      |                   | $          | 367 |   |

 

The accompanying notesare an integral part of these financial statements.

8

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** **

**HILAND PARTNERS,LPConsolidated Statement of Changes in Owners’ Equity and Comprehensive IncomeFor the Nine Months Ended September 30, 2006 (Unaudited)**
| ** **                                                                           | ** ** | ** **                                                  | ** ** | ** **       | ** ** | ** **   | ** ** | ** **       | ** ** | **Accumulated**   | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|------------------|------------|--------------|------------|------------------|------------|-------------------|------------|------------|------------|-------------------|------------|
| ** **                                                                           | ** ** | ** **                                                  | ** ** | ** **       | ** ** | **General**  | ** ** | ** **       | ** ** | **Other**         | ** ** | ** ** | ** ** | **Total**         | ** ** |
| ** **                                                                           | ** ** | **Common**                                                  | ** ** | **Subordinated** | ** ** | **Partner**  | ** ** | **Unearned**     | ** ** | **Comprehensive** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                           | ** ** | **Units**                                                   | ** ** | **Units**        | ** ** | **Interest** | ** ** | **Compensation** | ** ** | **Income**        | ** ** | **Total**  | ** ** | **Income**        | ** ** |
| ** **                                                                           | ** ** | **(in thousands, except unit amounts)** | ** ** |
| Balance, January  1, 2006                                                            |       | $                                                           | 110,027    |             | $          | 25,126       |       | $                | 2,676      |              | $          | (289       | )          | $                 | 1,049      |   | $ | 138,589 |   |   |   |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Elimination of  unearned compensation upon adoption of SFAS 123(R)              |       | (289                                                        | )          | —           |       | —       |       | 289              |       | —            |       | —     |       |              |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Issuance of  761,714 common units to our general partner                             |       | 34,300                                                      |       | —           |       | 700          |       | —           |       | —            |       | 35,000     |       |              |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Proceeds from  47,533 unit options exercise                                          |       | 1,093                                                       |       | —           |       | 23           |       | —           |       | —            |       | 1,116      |       |              |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Issuance of 8,000  restricted common units                                           |       |                                                        |       | —           |       | 7            |       | —           |       | —            |       | 7          |       |              |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Periodic cash  distributions                                                         |       | (9,067                                                      | )          | (7,956           | )          | (1,346       | )          | —           |       | —            |       | (18,369    | )          |              |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Unit based  compensation                                                             |       | 338                                                         |       | —           |       | —       |       | —           |       | —            |       | 338        |       |              |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Other  comprehensive income reclassified to income on closed derivative transactions |       | —                                                      |       | —           |       | —       |       | —           |       | (2,368            | )          | (2,368     | )          | $                 | (2,368     | ) |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Change in fair  value of derivatives                                                 |       | —                                                      |       | —           |       | —       |       | —           |       | 5,829             |       | 5,829      |       | 5,829             |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Net income                                                                           |       | 5,133                                                       |       | 4,384            |       | 1,589        |       | —           |       | —            |       | 11,106     |       | 11,106            |       |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Comprehensive  income                                                                |       |                                                        |       |             |       |         |       |             |       |              |       |       |       | $                 | 14,567     |   |
|                                                                                 |       |                                                        |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Balance, September 30,  2006                                                         |       | $                                                           | 141,535    |             | $          | 21,554       |       | $                | 3,649      |              | $          | —     |       | $                 | 4,510      |   | $ | 171,248 |   |   |   |

 

The accompanying notes are an integral part of thesefinancial statements.

9

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**HILANDPARTNERS, LP**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005**

**(inthousands, except unit information or unless otherwise noted)**

 

**Note 1: Organization, Basis of Presentation and Principles of Consolidation**

HilandPartners, LP, a Delaware limited partnership (“we,” “us,” “our” or “thePartnership”), was formed in October 2004 to acquire and operate certainmidstream natural gas plants, gathering systems and compression and waterinjection assets located in the states of Oklahoma, North Dakota, Wyoming,Texas and Mississippi that were previously owned by Continental Gas, Inc. (“Predecessor”or “CGI”) and Hiland Partners, LLC. We commenced operations onFebruary 15, 2005, and concurrently with the completion of our initialpublic offering, CGI contributed a substantial portion of its net assets to us.

CGI constitutesour predecessor. The transfer of ownership of net assets from CGI to usrepresented a reorganization of entities under common control and was recordedat historical cost. Accordingly, the financial statements include thehistorical operations of CGI prior to the transfer to us. CGI was formed in1990 as a wholly owned subsidiary of Continental Resources, Inc. (“CRI”).

CGI operated inone segment, midstream, which involved the gathering, compressing, dehydrating,treating, and processing of natural gas and fractionating natural gas liquids,or NGLs. CGI historically has owned all of our natural gas gathering,processing, treating and fractionation assets other than our Worland gatheringsystem and our Bakken gathering system. Hiland Partners, LLC historicallyowned our Worland gathering system and our compression services assets, whichwe acquired on February 15, 2005, and our Bakken gathering system. Sinceour initial public offering, we have operated in two segments which consist ofmidstream and compression services segments. On September 26, 2005, weacquired Hiland Partners, LLC, which at such time owned the Bakken gatheringsystem, for $92.7 million, $35.0 million of which was used to retireoutstanding Hiland Partners, LLC indebtedness.  On May 1, 2006, we acquired the Kinta Areagathering assets from Enogex Gas Gathering, L.L.C., consisting of certaineastern Oklahoma gas gathering assets, for $96.4 million.  We financed this acquisition with $61.2million of borrowings from our credit facility and $35.0 million of proceedsfrom the issuance to Hiland Partners GP, LLC, our general partner, of 761,714common units and 15,545 general partner equivalent units, both at $45.03 perunit.

On September 25,2006, certain affiliated unitholders contributed (i) all of the membershipinterests in our general partner, which owns the 2% general partner interestand all of the incentive distribution rights in us and (ii) a 57.0% limitedpartner interest (including 761,714 common units held by our general partner)in us to Hiland Holdings GP, LP, a publicly owned limited partnership (NASDAQ: HPGP), in exchange for 13,550,000 limitedpartner units, representing a 62.7% ownership in Hiland Holdings GP, LP.  HilandPartners GP Holdings, LLC, a Delaware limited liability company formed on May10, 2006, is the general partner of Hiland Holdings GP, LP.

The unauditedconsolidated financial statements for the three and nine month periods ended September 30, 2006and 2005 included herein have been prepared pursuant to the rules andregulations of the United States Securities and Exchange Commission (the “SEC”).The interim financial statements reflect all adjustments, which are in theopinion of our management, necessary for a fair presentation of our results forthe interim periods. Such adjustments are considered to be of a normalrecurring nature. Results of operations for the three and nine month periodsended September 30, 2006 are not necessarily indicative of the results ofoperations that will be realized for the year ending December 31, 2006.  The accompanying consolidated financialstatements and notes thereto should be read in conjunction with the consolidatedfinancial statements and notes thereto included in our Form 10-K for thefiscal year ended December 31, 2005.

***Principles of Consolidation***

The consolidatedfinancial statements include our accounts and those of our subsidiaries. Allsignificant intercompany transactions and balances have been eliminated. Theconsolidated financial statements include the net assets and operations ofassets owned by CGI (our predecessor) from January 1, 2005, certain assets ofHiland Partners, LLC that were contributed to us concurrently with thecompletion of our initial public offering on February 15, 2005 and theremaining net assets and operations of Hiland Partners, LLC acquired effectiveSeptember 1, 2005.

***Use of Estimates***

The preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

10

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***Fair Value of Financial Instruments***

Our financialinstruments, which require fair value disclosure, consist primarily of cash andcash equivalents, accounts receivable, financial derivatives, accounts payableand long-term debt. The carrying value of cash and cash equivalents, accountsreceivable and accounts payable are considered to be representative of theirrespective fair values, due to the short maturity of these instruments.Derivative instruments are reported in the accompanying consolidated financialstatements at fair value in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 133, “Accounting for Derivative Instruments andHedging Activities,” as amended.  Fair value of our derivativeinstruments is determined based on management estimates through utilization ofmarket data including forecasted forward natural gas and NGL prices as afunction of forward NYMEX natural gas and light crude prices. The fairvalue of long-term debt approximates its carrying value due to the variableinterest rate feature of such debt.

***Comprehensive Income (Loss)***

Comprehensiveincome includes net income and other comprehensive income, which includes, butis not limited to, changes in the fair value of derivative financialinstruments. Pursuant to SFAS No. 133, we record deferred unrealized hedgegains and losses on our derivative financial instruments that qualify as cashflow hedges as other comprehensive income and record changes in the fair valueof our derivative financial instruments that qualify as cash flow hedges asother comprehensive income.  Presentedbelow is our comprehensive income for the three and nine months ended September30, 2006 and 2005:

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Net income                                             |       | $                                | 3,738      |                            | $          | 2,684 |   | $ | 11,106 |   | $ | 6,198 |   |
| Closed  derivative transacitons reclassified to income |       | (1,355                           | )          | —                          |       | (2,368 | ) | — |   |
| Change in fair  value of derivatives                   |       | 5,331                            |       | —                          |       | 5,829 |   | — |   |
| Comprehensive income                                   |       | $                                | 7,714      |                            | $          | 2,684 |   | $ | 14,567 |   | $ | 6,198 |   |

 

***Net Income per Limited Partner Unit***

Net income perlimited partner unit is computed based on the weighted-average number of commonand subordinated units outstanding during the period. The computation of dilutednet income per limited partner unit further assumes the dilutive effect of unitoptions and restricted unit awards. Net income per limited partner unit iscomputed by dividing net income applicable to limited partners, after deductingthe general partner’s 2% interest and incentive distributions, and, for thenine month period ended September 30, 2005, after deducting net incomeattributable to the Predecessor (before February 15, 2005), by both thebasic and diluted weighted-average number of limited partnership unitsoutstanding.

***Share-Based Compensation***

Our generalpartner, Hiland Partners GP, LLC adopted the Hiland Partners, LP Long-TermIncentive Plan for its employees and directors of our general partner andemployees of its affiliates.  The long-term incentive plan currentlypermits an aggregate of 680,000 common units to be issued with respect to unitoptions, restricted units, and phantom units granted under the plan.  Nomore than 225,000 of the 680,000 common units may be issued with respect to vestedrestricted or phantom units.  The plan is administered by the compensationcommittee of our general partner’s board of directors. The plan willcontinue in effect until the earliest of (i) the date determined by the boardof directors of our general partner; (ii) the date that common units are nolonger available for payment of awards under the plan; or (iii) the tenthanniversary of the plan.

Our generalpartner’s board of directors or compensation committee may, in theirdiscretion, terminate, suspend or discontinue the long-term incentive plan atany time with respect to any units for which a grant has not yet beenmade.  Our general partner’s board of directors or its compensationcommittee also has the right to alter or amend the long-term incentive plan orany part of the plan from time to time, including increasing the number ofunits that may be granted, subject to unitholder approval if required by theexchange upon which the common units are listed at that time.  No changein any outstanding grant may be made, however, that would materially impair therights of the participant without the consent of the participant. Under theunit option grant agreement, granted options of common units will vest andbecome exercisable in one-third increments on the anniversary of the grant dateover three years. Vested options are exercisable within the option’scontractual life of ten years after the grant date.

In October 1995the FASB issued SFAS No. 123, “Share-Based Payment,” which was revised inDecember 2004 (“SFAS 123R”).  SFAS 123Rrequires that the compensation cost relating to share-based paymenttransactions be recognized in the financial statements and that cost bemeasured based on the fair value of the equity or liability instruments issued.We adopted SFAS 123R as of January 1, 2006 and applied SFAS 123R using thepermitted modified prospective method beginning as of the same date and ourunearned deferred compensation of $289 as of January 1, 2006 has beeneliminated against common unit equity. Prior to January 1,

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2006 we recorded anyunamortized compensation related to restricted unit awards as unearnedcompensation in equity. We expect no change to our cash flow presentation fromthe adoption of SFAS 123R since no tax benefits are recognized by us as a passthrough entity. Our compensation expense for these awards is recognized onthe graded vesting attribution method. Units to be issued under our unitincentive plan may be from newly issued units. No compensation expense wasrecognized in 2005 for our unit options granted during 2005. Prior to ouradoption of SFAS 123R on January 1, 2006, we applied Accounting PrinciplesBoard Opinion No. 25 and related interpretations in accounting for ourunit-based compensation awards. The following pro forma data was calculated asif compensation cost for our unit-based compensation awards during the threeand nine month periods ended September 30, 2005 was determined based upon thefair value at the grant date consistent with the methodology prescribed underSFAS No. 123.

 
| ** **                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                    | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Net income as  reported                                       |       | $                                | 2,684      |                             | $          | 6,198 |   |
| Share based  compensation adjustment                          |       | (289                             | )          | (739                             | )          |
| Pro forma net  income                                         |       | 2,395                            |       | 5,459                            |       |
| Less income  attributable to predecessor                      |       | —                           |       | (493                             | )          |
| Less general  partner interest                                |       | (60                              | )          | (111                             | )          |
| Limited  partner’s interest in pro forma net income      |       | $                                | 2,335      |                             | $          | 4,855 |   |
|                                                          |       |                             |       |                             |       |
| Net income per  limited partner unit as reported - basic      |       | $                                | 0.38       |                             | $          | 0.82 |   |
| Net income per  limited partner unit as reported - diluted    |       | $                                | 0.38       |                             | $          | 0.82 |   |
| Adjustment -  basic                                           |       | $                                | (0.04      | )                                | $          | (0.11 | ) |
| Adjustment -  diluted                                         |       | $                                | (0.04      | )                                | $          | (0.11 | ) |
| Proforma net  income per limited partner unit - basic         |       | $                                | 0.34       |                             | $          | 0.71 |   |
| Proforma net  income per limited partner unit - diluted       |       | $                                | 0.34       |                             | $          | 0.71 |   |
| Weighted average  limited partner units outstanding - basic   |       | 6,800,000                        |       | 6,800,000                        |       |
| Weighted average  limited partner units outstanding - diluted |       | 6,844,000                        |       | 6,830,000                        |       |

 

The fair value of each option granted was estimated on the dateof grant using the American Binomial option-pricing model that used theassumptions noted below. Expected and weighted-average volatility is based onour peer group volatility averages as determined on the option grant dates.Expected volatility of options granted ranged from 16% to 31% andweighted-average volatility ranged from 18% to 30%. Expected lives of6.0 years are calculated by the simplified method as prescribed under SECStaff Accounting Bulletin 107 and represent the period of time that unit optionsgranted are expected to be outstanding. The risk-free interest rate for periodswithin the contractual life of the option is based on the ten-year U.S.Treasury yield in effect at the time of grant. The exercise price of theoptions granted equaled the market price of the units on the grant date.
| ** **                   | ** ** | **Nine months ended  September 30, 2006** | ** ** | **Year Ended  December 31, 2006** | ** ** |
|------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Expected  volatility         |       | 16.1% - 20.2                                                  | %          | 20.2% - 31.0                                     | %          |
|                         |       |                                                          |       |                                             |       |
| Weighted-average  volatility |       | 18.0                                                          | %          | 29.4                                             | %          |
|                         |       |                                                          |       |                                             |       |
| Expected  dividend yield     |       | 6.4                                                           | %          | 5.2                                              | %          |
|                         |       |                                                          |       |                                             |       |
| Risk-free interest rate      |       | 4.5                                                           | %          | 4.5                                              | %          |

 

The following table summarizes informations about outstanding optionsfor the nine months ended September 30, 2006.

 
| ** **                         | ** ** | ** ** | ** ** | ** **         | ** ** | **Weighted-**   | ** ** | ** **         | ** ** |
|------------------------------------|------------|------------|------------|--------------------|------------|-----------------|------------|--------------------|------------|
| ** **                         | ** ** | ** ** | ** ** | **Weighted**       | ** ** | **Average**     | ** ** | ** **         | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Average**        | ** ** | **Remaining**   | ** ** | **Aggregate**      | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **Exercise**       | ** ** | **Contractual** | ** ** | **Intrinsic**      | ** ** |
| **Options**                        | ** ** | **Units**  | ** ** | **Price ($)** | ** ** | **Term**        | ** ** | **Value ($)** | ** ** |
|                               |       |       |       |               |       |            |       |               |       |
| Outstanding at  January 1, 2006    |       | 167,500    |       | $                  | 24.70      |            |       |               |       |   |
|                               |       |       |       |               |       |            |       |               |       |
| Granted                            |       | 28,000     |       | $                  | 39.62      |            |       |               |       |   |
|                               |       |       |       |               |       |            |       |               |       |
| Exercised                          |       | (47,533    | )          | $                  | 23.01      |            |       |               | $          | 811 |   |
|                               |       |       |       |               |       |            |       |               |       |
| Forfeited or  expired              |       | (13,333    | )          | $                  | 22.50      |            |       |               |       |   |
|                               |       |       |       |               |       |            |       |               |       |
| Outstanding at  September 30, 2006 |       | 134,634    |       | $                  | 28.65      |            | 8.6        |               | $          | 2,413 |   |
|                               |       |       |       |               |       |            |       |               |       |
| Exercisable at  September 30, 2006 |       | 7,801      |       | $                  | 33.82      |            | 8.3        |               | $          | 99 |   |

 

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The weightedaverage grant date fair value of the 55,334 unit options vested during the ninemonths ended September 30, 2006 was $5.17 per unit. The weighted average grantdate fair value of the 28,000 unit options granted during the nine months endedSeptember 30, 2006 was $4.33 per unit. As of September 30, 2006, there was $299of total unrecognized compensation cost related to unvested unit basedcompensation arrangements granted under our Plan. This cost is expected to berecognized over a weighted-average period of 1.3 years.

On April 14, 2006,13,333 of the unit options issued on February 14, 2005, were forfeited. Weassumed no forfeitures in our fair value calculations, as we believe thisforfeiture is an isolated incident and is not indicative of the future.  Compensation expense for the three and ninemonths ended September 30, 2006 has been reduced by $7 and $13, respectively,as a result of the forfeiture.

During the yearended December 31, 2005, we issued 8,000 restricted common units tonon-employee board members of our general partner. A restricted unit is acommon unit that is subject to forfeiture.  Upon vesting, the granteereceives a common unit that is not subject to forfeiture.  The restrictedunits vest over a four-year period from the date of issuance. The weightedaverage fair value at grant date was $39.69 per unit. Periodic distributions onthe restricted units are held in trust by our general partner until the unitsvest. As of September 30, 2006, one-fourth, or 2,000 of the restricted unitshad vested and were converted to common units.

As provided for inthe long-term incentive plan, each non-employee board member of our generalpartner on each anniversary date of the initial award is entitled to receive anadditional 1,000 restricted common units. During the three months ended September 30, 2006 we issued 4,000restricted common units with a weighted average fair value of $44.49 per unitto four non-employee board members of our general partner.

On August 11,2006, our general partner elected two additional non-employee board members andissued 4,000 restricted common units which vest over four years.  The fair value at grant date was $44.00 perunit. Periodic distributions on these restricted units will be held in trust byour general partner until the units vest.

Compensationexpense related to the 8,000 restricted units issued is to be recognized overtheir respective four-year vesting period on a straight-line basis. During thethree months ended September 30, 2006, we recorded $11 of expense and willexpense another $352 over the next four years. Our general partner contributed $7 to us to maintain its 2% ownershipinterest.

As a result ofadopting SFAS 123R, our net income was reduced by $89 and $268 for the threeand nine months ended September 30, 2006, respectively. Basic and diluted earningsper unit were reduced by $0.01 and $0.03 each for the three and nine monthsended September 30, 2006, respectively as a result of the additionalcompensation recognized under SFAS 123R.

***Accounting for Asset Retirement Obligations***

SFASNo. 143, “Accounting for Asset Retirement Obligations,” requires entitiesto record the fair value of a liability for an asset retirement obligation inthe period in which it is incurred and a corresponding increase in the carryingamount of the related long-lived asset. Subsequently, the asset retirement costis allocated to expense using a systematic and rational method and theliability is accreted to measure the change in liability due to the passage oftime. The primary impact of this standard relates to dismantling and siterestoration of certain of our plants and pipelines.

The followingtable summarizes our activity related to asset retirement obligations for theindicated period:
| Asset retirement  obligation, January 1, 2006       |   | $     | 1,024  |   |
|----------------------------------------------------------|--------|-------|--------|--------|
| Acquired in  Kinta Area asset acquisition on May 1, 2006 |   | 1,106 |   |
| Plus: accretion  expense                                 |   | 47    |   |
| Asset retirement  obligation, September 30, 2006         |   | $     | 2,177  |   |

*** ***

***Recent Accounting Pronouncements***

InOctober 1995, the FASB issued SFAS No. 123, “Share-BasedPayments,” which was revised in December 2004 (collectively, “SFAS 123R”).SFAS 123R requires that the compensation cost relating to share-basedpayment transactions be recognized in financial statements and that cost willbe measured based on the fair value of the equity or liability instrumentsissued. This standard requires entities to measure the cost of employeeservices received in exchange for stock or unit options based on the grant-datefair value of the award, and to recognize the cost over the period the employeeis required to provide services for the award. We have applied SFAS 123Ras of our first interim period beginning on January 1, 2006 and have usedthe permitted modified prospective method beginning as of the same date.

In September 2006,the FASB issued SFAS No. 157 “Fair Value Measurements.”  SFAS No. 157 defines fair value as the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the

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measurement date,establishes a framework for measuring fair value in generally acceptedaccounting principles (GAAP) such as fair value hierarchy used to classify thesource of information used in fair value measurements (i.e., market based ornon-market based) and expands disclosure about fair value measurements based ontheir level in the hierarchy.  ThisStatement applies to derivatives and other financial instruments, whichStatement 133, *Accounting for DerivativeInstruments and Hedging Activities*, requires be measured at fairvalue at initial recognition and for all subsequent periods. This Statement iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007 and interim periods within those fiscal years. We will applythe provisions of the Statement prospectively in our first interim period inthe fiscal year beginning on January 1, 2008 and we do not expect a change inour methodologies of fair value measurements.

In September 2006,the SEC staff issued Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements.”  SAB 108 wasissued to provide consistency between how registrants quantify financialstatement misstatements. Historically, there have been two widely used methodsfor quantifying the effects of financial statement misstatements.  These methods are referred to as the “roll-over”and “iron curtain” method.  The roll-overmethod quantifies the amount by which the current year income statement ismisstated.  Exclusive reliance on anincome statement approach can result in the accumulation of errors on thebalance sheet that may not have been material to any individual incomestatement, but which may misstate one or more balance sheet accounts. The ironcurtain method quantifies the error as the cumulative amount by which thecurrent year balance sheet is misstated. Exclusive reliance on a balance sheet approach can result indisregarding the effects of errors in the current year income statement thatresults from the correction of an error existing in previously issued financialstatements.  SAB 108 established anapproach that requires quantification of financial statement misstatementsbased on the effects of the misstatement on each of the company’s financialstatements and the related financial statement disclosures.  This approach is commonly referred to as the “dualapproach” because it requires quantification of errors under both the roll-overand iron curtain methods. We will initially apply SAB 108 in connection withthe preparation of our annual financial statements for the year ending December31, 2006 and we do not expect to record an adjustment.

**Note 2:  Acquisitions**

On May 1,2006, we acquired certain gas gathering assets from Enogex Gas Gathering,L.L.C. for $96.4 million cash, including certain closing costs, financed withthe issuance of 761,714 common units and 15,545 general partner equivalentunits to our general partner for proceeds of $35.0 million and borrowings of$61.2 million under our credit facility. We refer to these assets as the Kinta Area gathering assets. A determination was made by our management ofthe fair value of these assets and liabilities as required by SFAS 141 “BusinessCombinations,” primarily using current replacement cost for the acquired gasgathering assets and related equipment less estimated accumulated depreciationon such replacement costs; and estimated discounted cash flows arising fromfuture renegotiated customer contracts. The acquired assets at the time of the acquisition, which are located inthe eastern Oklahoma Arkoma Basin, had approximately 672 wellhead receiptpoints and included five separate low pressure natural gas gathering systemsconsisting of over 569 miles of natural gas gathering pipelines and 23 compressorswith an aggregate of approximately 40,000 horsepower.  The natural gas gathering systems operateunder contracts with producers that provide for services under fixed-feearrangements.  We will operate the KintaArea gathering assets substantially differently than were operated by theprevious owner.  Since there was nosufficient continuity of the Kinta Area gathering assets’ operations prior toand after our acquisition, disclosure of prior financial information would notbe material to an understanding of future operations.  Therefore, the acquisition has been recordedas a purchase of assets and not of a business and no pro forma financialinformation is required to be presented.

The following tablepresents the resulting allocation to the net assets acquired and liabilitiesassumed on May 1, 2006:

 
| Pipelines,  including right of ways  |   | $      | 56,175 |   |
|--------------------------------------|--------|--------|--------|--------|
| Compressors                          |   | 22,221 |   |
| Other equipment  and buildings       |   | 8,618  |   |
| Customer  relationships              |   | 10,492 |   |
|                                 |   | 97,506 |   |
| Asset retirement  obligation assumed |   | 1,106  |   |
| Net assets acquired                  |   | $      | 96,400 |   |

 

The Kinta Areagathering assets and operations are included in the consolidated financialstatements from May 1, 2006 forward.

OnSeptember 26, 2005, we completed our acquisition of HilandPartners, LLC, an Oklahoma limited liability company, for approximately$92.7 million in cash, $35.0 million of which was used to retireoutstanding Hiland Partners, LLC indebtedness. The effective date of theacquisition was September 1, 2005. Hiland Partners, LLC’s principal assetwas the Bakken gathering system located in Richland County, Montana. At thetime of the acquisition, the Bakken gathering system consisted of approximately256 miles of gas gathering pipeline, a natural gas processing plant, twocompressor stations, which were comprised of three compressors with anaggregate of approximately 4,434 horsepower, and one fractionation facility.The Bakken processing plant and a portion of the gathering system becameoperational on November 8, 2004.  Tofacilitate the closing of the acquisition, we amended our senior securedrevolving credit facility to increase our borrowing capacity under the facilityfrom $55.0 million to $125.0 million,

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consisting of a$117.5 million acquisition facility and a $7.5 million workingcapital facility.  We used a portion ofthis increased capacity to fund the acquisition.

To the extent ofour non-controlling ownership of Hiland Partners, LLC, the acquisition wasaccounted for using the purchase method of accounting under SFAS No. 141, “BusinessCombinations.” As of the date of our acquisition, Hiland Partners, LLC wasan entity partially owned by an affiliate who, at the time, was a controllingmember of our general partner. Accordingly, 49% of the Bakken gathering systemassets, for which estimated fair value was in excess of historical basis, havebeen recorded at historical cost and 51% of the Bakken gathering system assetshave been recorded at fair value. A cash distribution of $27.8 millionmade to this affiliate, as reported as a reduction of owners’ equity, reflectsthe difference in the purchase price paid to this affiliate and his cost basisin the net assets of Hiland Partners, LLC. The fair value of the assetsacquired has also been reduced by imputed interest expense fromSeptember 1, 2005, the effective date of the acquisition, through theclosing date, September 26, 2005. The following table presents theresulting allocation to the net assets acquired and liabilities assumed at theeffective date of acquisition:

 
| Cash and cash  equivalents                                                                        |   | $      | 300    |   |
|---------------------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Accounts  receivable                                                                              |   | 3,708  |   |
| Other current  assets                                                                             |   | 20     |   |
| Property, plant  and equipment                                                                    |   | 49,873 |   |
| Customer  contracts                                                                               |   | 17,589 |   |
| Total assets  acquired                                                                            |   | 71,490 |   |
| Accounts payable                                                                                  |   | (6,217 | )      |
| Accrued  liabilities                                                                              |   | (125   | )      |
| Total  liabilities assumed                                                                        |   | (6,342 | )      |
| Net assets of  Hiland Partners, LLC                                                               |   | 65,148 |   |
| Imputed interest  expense                                                                         |   | (289   | )      |
| Purchase price of net  assets of Hiland Partners, LLC less distribution to the controlling member |   | $      | 64,859 |   |

 

In connection withour formation and our initial public offering on February 15, 2005,certain assets and liabilities of Hiland Partners, LLC, excluding the Bakkenassets, were contributed to us. In consideration for the contribution, thenon-managing members of Hiland Partners, LLC received 247,868 of our commonunits and 1,404,586 of our subordinated units. Immediately following theclosing of the offering, 104,009 of the common units were redeemed forapproximately $2.2 million. The managing member of Hiland Partners, LLCalso received 5,059 of our common units and 28,665 of our subordinated units,none of which were redeemed. The acquisition of the assets of Hiland Partners,LLC was accounted for as a purchase and, as a result, these assets wererecorded at their fair value at the time of purchase.

The followingtable presents the fair value of the assets and liabilities acquired fromHiland Partners, LLC on February 14, 2005.

 
| Accounts  receivable and other current assets                |   | $      | 162    |   |
|--------------------------------------------------------------|--------|--------|--------|--------|
| Property and  equipment                                      |   | 31,600 |   |
| Intangible  assets                                           |   | 26,800 |   |
| Other assets                                                 |   | 105    |   |
| Total assets acquired                                        |   | 58,667 |   |
| Less accounts  payable and other current liabilities assumed |   | (741   | )      |
| Less current  portion of long-term debt assumed              |   | (8,879 | )      |
| Less asset  retirement obligation assumed                    |   | (398   | )      |
| Fair value of net  assets acquired                           |   | $      | 48,649 |   |

 

The operations ofthe Bakken gathering system are included in the statement of operations andstatement of cash flows from September 1, 2005 forward. The operations of theassets acquired from Hiland Partners, LLC are included in the statement ofoperations and statement of cash flows from February 15, 2005 forward. Had theacquisitions been made effective January 1, 2005, the operations of the assetswould have been included in our consolidated financial statements for theindicated periods with the following pro forma impact on the consolidatedcombined statements of operations.

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| ** **                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                    | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Revenues as  reported                                         |       | $                                | 41,925     |                             | $          | 98,306 |   |
| Revenues from  acquired interests                             |       | 1,869                            |       | 18,649                           |       |
| Pro forma revenues                                            |       | $                                | 43,794     |                             | $          | 116,955 |   |
|                                                          |       |                             |       |                             |       |
| Net income as  reported                                       |       | $                                | 2,684      |                             | $          | 6,198 |   |
| Loss from  acquired interests                                 |       | (622                             | )          | (4,176                           | )          |
| Pro forma net  income                                         |       | 2,062                            |       | 2,022                            |       |
| Less income  attributable to predecessor                      |       | —                           |       | 493                              |       |
| Less general  partner interest in proforma net income         |       | 52                               |       | 41                               |       |
| Limited  partners’ interest in proforma net income       |       | $                                | 2,010      |                             | $          | 1,488 |   |
|                                                          |       |                             |       |                             |       |
| Proforma net  income per limited partner unit - basic         |       | $                                | 0.30       |                             | $          | 0.22 |   |
| Proforma net  income per limited partner unit - diluted       |       | $                                | 0.29       |                             | $          | 0.22 |   |
| Weighted average  limited partner units outstanding - basic   |       | 6,800,000                        |       | 6,800,000                        |       |
| Weighted average  limited partner units outstanding, -diluted |       | 6,844,000                        |       | 6,830,000                        |       |

** **

**Note 3:  Propertyand Equipment**

** **
| ** **                                       | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Land                                             |       | $                      | 255        |                  | $          | 225 |   |
| Construction in  progress                        |       | 41,349                 |       | 3,676                 |       |
| Midstream  pipeline, plants and compressors      |       | 219,324                |       | 122,927               |       |
| Compression and  water injection equipment       |       | 19,268                 |       | 19,264                |       |
| Other                                            |       | 2,419                  |       | 1,689                 |       |
|                                             |       | 282,615                |       | 147,781               |       |
| Less:  accumulated depreciation and amortization |       | 39,028                 |       | 27,066                |       |
|                                             |       | $                      | 243,587    |                  | $          | 120,715 |   |

 

We capitalizedinterest of $479 and $811 during the three and nine months ended September 30,2006, respectively.  As of September 30,2006 we have capitalized $843 of interest relating to constructed assets placedin service and construction in progress. We did not capitalize any interest during the same periods in 2005.

**Note 4:  IntangibleAssets**

Intangible assets consist of the acquired value ofcustomer relationships, existing contracts to sell natural gas and other NGLsand compression contracts, which do not have significant residual value. Thecustomer relationships and the contracts are being amortized over estimatedlives of ten years. We review intangible assets for impairment whenever eventsor circumstances indicate that the carrying amounts may not be recoverable. Ifsuch a review should indicate that the carrying amount of intangible assets isnot recoverable, we reduce the carrying amount of such assets to fair valuebased on the discounted probable cash flows of the intangible assets. Noimpairment of intangible assets has been recorded as of September 30,2006.  Intangible assets consistedof the following at September 30, 2006 and December 31, 2005:

 
| ** **                     | ** ** | **As of**         | ** ** | **As of**         | ** ** |
|--------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                     | ** ** | **2006**               | ** ** | **2005**               | ** ** |
| Gas sales  contracts           |       | $                      | 25,585     |                   | $          | 25,585 |   |
| Compression  contracts         |       | 18,515                 |       | $                      | 18,515     |   |
| Customer  relationships        |       | 10,492                 |       | —                 |       |
|                           |       | 54,592                 |       | 44,100                 |       |
| Less accumulated  amortization |       | 6,666                  |       | 2,921                  |       |
| Intangible assets, net         |       | $                      | 47,926     |                   | $          | 41,179 |   |

 

There were no intangible assets prior to February 15, 2005.  Estimated aggregate amortization expense foreach of the five 

16

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succeeding fiscal yearsis $5,459 from 2006 through 2010 and a total of $20,631 for all yearsthereafter.

**Note 5:  Derivatives**

We have enteredinto certain financial swap instruments that are classified as cash flow hedgesin accordance with SFAS No. 133, as amended, and relate to forecasted sales in2006, 2007 and 2008. We entered into these instruments to hedge forecasted naturalgas and NGL sales or purchases against the variability in expected future cashflows attributable to changes in commodity prices. Under all but one of thesecontractual swap agreements with our counterparties, we receive a fixed priceand pay a floating price based on certain indices for the relevant contractperiod as the underlying natural gas or NGL is sold. In one agreement, we pay afixed price and receive a floating price based on certain indices for therelevant contract period as the underlying natural gas is purchased.

We formallydocument all relationships between hedging instruments and the items beinghedged, including our risk management objective and strategy for undertakingthe hedging transactions. This includes matching the natural gas and NGLfutures, the “sold fixed for floating price” or “buy fixed for floating price”contracts, to the forecasted transactions. We assess, both at the inception ofthe hedge and on an ongoing basis, whether the derivatives are highly effectivein offsetting changes in the fair value of hedged items. Highly effective isdeemed to be a correlation range from 80% to 125% of the change in cash flowsof the derivative in offsetting the cash flows of the hedged transaction. If itis determined that a derivative is not highly effective as a hedge or it hasceased to be a highly effective hedge, due to the loss of correlation betweenchanges in natural gas or NGL reference prices under a hedging instrument andactual natural gas or NGL prices, we will discontinue hedge accounting for thederivative and subsequent changes in fair value for the derivative will berecognized immediately into earnings. We assess effectiveness using regressionanalysis and ineffectiveness using the dollar offset method.

Derivatives are recordedon our consolidated balance sheet as assets or liabilities at fair value. Forderivatives qualifying as hedges, the effective portion of changes in fairvalue are recognized in owners’ equity as accumulated other comprehensiveincome and reclassified to earnings when the underlying hedged physicaltransaction closes. For non-qualifying derivatives and for the ineffectiveportion of qualifying derivatives, changes in fair value are recognized inearnings as they occur. Actual amounts that will be reclassified will vary as aresult of future changes in prices. Hedge ineffectiveness is recorded in incomewhile the hedge contract is open and may increase or decrease until settlementof the contract. Realized cash gains and losses on closed/settled instrumentsare reflected in the contract month being hedged as an adjustment to ourmidstream revenue. During the three months ended September 30, 2006 wereclassified net gains of $1,355 on closed/settled hedge transactions tomidstream revenues out of other comprehensive income and also recorded $5,331to other comprehensive income for the favorable change in fair value of openderivatives.  During the three and ninemonths ended September 30, 2006, we recorded losses of $31 and gains of $133,respectively, on the ineffective portions of our qualifying open derivativetransactions. At September 30, 2006, our accumulated other comprehensive incomerelated to derivatives was $4,510. Of this amount, we anticipate $2,596 will bereclassified to earnings during the next twelve months and $1,914 will bereclassified to earnings in subsequent periods. We had no derivatives orderivative transactions during the three or nine months ended September 30,2005.  The fair value of derivativeassets and liabilities are as follows for the indicated periods:
| ** **                                        | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                        | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                                              |       |                   |       |                  |       |
| Fair value of  derivative assets - current        |       | $                      | 4,322      |                  | $          | 868 |   |
| Fair value of  derivative assets - long term      |       | 2,549                  |       | 181                   |       |
| Fair value of  derivative liabilities - current   |       | (1,671                 | )          | —                |       |
| Fair value of  derivative liabilities - long term |       | (557                   | )          | —                |       |
| Net fair value  of derivatives                    |       | $                      | 4,643      |                  | $          | 1,049 |   |
|                                              |       |                   |       |                  |       |

Theterms of our derivative contracts currently extend as far as December2008.  Our counterparty to all of our derivativecontracts is BP Energy Company. Set forth below is the summarized notionalamount and terms of all instruments held for price risk management purposes atSeptember 30, 2006.

17

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| ** **                                                 | ** ** | ** ** | ** ** | ** **           | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------|------------|------------|------------|----------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | ** ** | ** ** | **Average**          | ** ** | **Asset**           | ** ** |
| **Description and Production Period**       | ** ** | **Volume** | ** ** | **Fixed Price** | ** ** | **(Liability)**     | ** ** |
|                                                       |       |       |       |                 |       |                |       |
| Natural Gas - Sold  Fixed for Floating Price Swaps         |       | (MMBtu)    |       | (per  MMBtu)         |       |                |       |
| October 2006 -  September 2007                             |       | 1,620,000  |       | $                    | 8.26       |                | $          | 4,280 |   |
| October 2007 - December  2008                              |       | 2,025,000  |       | $                    | 8.00       |                | 2,544      |   |
|                                                       |       |       |       |                 |       | $                   | 6,824      |   |
|                                                       |       |       |       |                 |       |                |       |
| Natural Gas - Buy Fixed  for Floating Price Swaps          |       | (MMBtu)    |       | (per  MMBtu)         |       |                |       |
| October 2006 -  September 2007                             |       | 600,000    |       | $                    | 8.87       |                | $          | (1,516 | ) |
| October 2007 - March  2008                                 |       | 300,000    |       | $                    | 8.87       |                | (398       | ) |
|                                                       |       |       |       |                 |       | $                   | (1,914     | ) |
|                                                       |       |       |       |                 |       |                |       |
| Natural Gas Liquids -  Sold Fixed for Floating Price Swaps |       | (Bbls)     |       | (per  Gallon)        |       |                |       |
| October 2006 -  September 2007                             |       | 152,652    |       | $                    | 1.13       |                | $          | (113 | ) |
| October 2007 - March  2008                                 |       | 76,326     |       | $                    | 1.13       |                | (154       | ) |
|                                                       |       |       |       |                 |       | $                   | (267       | ) |

 

**Note 6:  Long-TermDebt**

|                     | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|---------------------|------------|------------------------|------------|-----------------------|------------|
| ** **          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **          | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Note payable - bank |       | $                      | 134,064    |                  | $          | 33,784 |   |
|                     |            |                        |            |                       |            |  |  |

 

OnFebruary 15, 2005, concurrently with the closing of our initial publicoffering, we entered into a three-year $55.0 million senior securedrevolving credit facility. The credit facility consisted of a$47.5 million senior secured revolving credit facility to be used forfunding acquisitions and other capital expenditures, issuance of letters ofcredit and general corporate purposes (the “revolving acquisition facility”)and a $7.5 million senior secured revolving credit facility to be used forworking capital and to fund distributions (the “revolving working capitalfacility”).

On September 26,2005, concurrently with the acquisition of Hiland Partners, LLC, weamended our credit facility to increase our borrowing capacity under thefacility from $55.0 million to $125.0 million, consisting of a$117.5 million acquisition facility and a $7.5 million working capitalfacility.  On September 26, 2005, weincurred $93.7 million of indebtedness under the credit facility inconnection with our acquisition of Hiland Partners, LLC.

On November 21,2005, we completed a public offering of our common units. We used $65.2 millionof the $66.1 million net proceeds from the offering to repay a majority of thecredit facility borrowings, which were used to fund the acquisition of HilandPartners, LLC.

On June 8,2006, we entered into a second amendment to our credit facility to, among otherthings, increase our borrowing base to $200 million and revise certaincovenants. The facility currently consists of a $191.0 million seniorsecured revolving credit facility to be used for funding acquisitions and othercapital expenditures, issuance of letters of credit and general corporatepurposes (the “revolving acquisition facility”); and a $9.0 million seniorsecured revolving credit facility to be used for working capital and to funddistributions (the “revolving working capital facility”).

In addition, ourcredit facility provides for an accordion feature, which permits us, if certainconditions are met, to increase the size of the revolving acquisition facilityby up to $150 million and allows for the issuance of letters of credit ofup to $15.0 million in the aggregate. The credit facility will mature inMay 2011. At that time, the agreement will terminate and all outstandingamounts thereunder will be due and payable.

Our obligationsunder the credit facility are secured by substantially all of our assets andguaranteed by us, and all of our subsidiaries, other than our operatingcompany, which is the borrower under the credit facility.

Indebtedness underthe credit facility will bear interest, at our option, at either (i) anAlternate Base Rate plus an applicable margin ranging from 50 to 125 basispoints per annum or (ii) LIBOR plus an applicable margin ranging from 150to 225 basis points per annum based on our ratio of consolidated funded debt toEBITDA. The Alternate Base Rate is a rate per annum equal to the greatest of(a) the Prime Rate in effect on such day, (b) the base CD rate ineffect on such day plus 1.50% and (c) the Federal Funds 

18

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effective rate in effect on such day plus 1¤2of 1%. A letter of credit fee will be payable for the aggregate amount ofletters of credit issued under the credit facility at a percentage per annumequal to 1.0%. An unused commitment fee ranging from 25 to 50 basis points perannum based on our ratio of consolidated funded debt to EBITDA will be payableon the unused portion of the credit facility. During any step-up period, theapplicable margin with respect to loans under the credit facility will beincreased by 35 basis points per annum and the unused commitment fee will beincreased by 12.5 basis points per annum.

The creditfacility prohibits us from making distributions to unitholders if any defaultor event of default, as defined in the credit facility, has occurred and iscontinuing or would result from the distribution. In addition, the creditfacility contains various covenants that limit, among other things, subject tocertain exceptions and negotiated “baskets,” our ability to incur indebtedness,grant liens, make certain loans, acquisitions and investments, make anymaterial changes to the nature of its business, amend its material agreements,including the Omnibus Agreement or enter into a merger, consolidation or saleof assets.

The creditfacility also contains covenants requiring us to maintain a maximumconsolidated funded debt to EBITDA ratio of 4.0:1.0, provided that in the eventwe make certain permitted acquisitions or capital expenditures, the creditfacility allows this ratio to increase to 4.75:1.0 for the following threefiscal quarters (a “step-up period”) and a minimum interest coverage ratio of3.0:1.0.

The creditfacility defines EBITDA as our consolidated net income, plus income taxexpense, interest expense, depreciation and amortization expense, amortizationof intangibles and organizational costs, non-cash unit based compensationexpense, and adjustments for non-cash gains and losses on specified derivativetransactions and for other extraordinary items.

Upon theoccurrence of an event of default as defined in the credit facility, thelenders may, among other things, be able to accelerate the maturity of thecredit facility and exercise other rights and remedies as set forth in thecredit facility.

The creditfacility limits distributions to our unitholders to available cash, as definedby the agreement, and borrowings to fund such distributions are only permittedunder the revolving working capital facility. The revolving working capitalfacility is subject to an annual “clean-down” period of 15 consecutive days inwhich the amount outstanding under the revolving working capital facility isreduced to zero.

As of September30, 2006, we had $134.1 million outstanding under the credit facility andwere in compliance with its financial covenants.

**Note 7:  Commitmentsand Contingencies**

We have executedvarious natural gas fixed price physical forward sales contracts onapproximately 100,000 MMBtu per month for the remainder of 2006 and all of 2007and 2008 with fixed prices ranging from $4.47 to $9.52 per MMBtu in 2006, $4.49to $9.13 per MMBtu in 2007 and $8.43 per MMBtu in 2008.  These contracts have been designated asnormal sales under SFAS No. 133 and are therefore not marked to market asderivatives.  A summary of our fixedprice physical forward sales contracts is presented in the table below:

|                                | ** ** | ** **  | ** ** | **Average**          | ** ** |
|--------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                     | ** ** | ** **  | ** ** | **Fixed Price** | ** ** |
| **Production period**     | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** |
| October 2006 -  September 2007 |       | 1,200,000   |       | $                    | 6.86       |   |
| October 2007 - December 2008   |       | 1,500,000   |       | $                    | 8.11       |   |

 

We maintain adefined contribution retirement plan for our employees under which we makediscretionary contributions to the plan based on a percentage of eligibleemployees’ compensation. Contributions to the plan are 5.0% of eligibleemployees’ compensation and resulted in expenses for the three months endedSeptember 30, 2006 and 2005 of $55 and $31, respectively.  Expense for the nine months ended September30, 2006 and 2005 was $141 and $72, respectively.

We jointlyparticipate with other affiliated companies in a self-insurance pool (the “Pool”)covering health and workers’ compensation claims made by employees up to thefirst $150 and $500, respectively, per claim. Any amounts paid above these arereinsured through third party providers. Premiums charged to the Partnershipare based on estimated costs per employee of the Pool. Property and generalliability insurance is maintained through third-party providers with a $100deductible on each policy.

The operation ofpipelines, plants and other facilities for gathering, compressing, treating, orprocessing natural gas, NGLs and other products is subject to stringent andcomplex laws and regulations pertaining to health, safety and the environment.Our management believes that compliance with federal, state or localenvironmental laws and regulations will not have a material adverse effect onour business, financial position or results of operations.

Although there areno regulatory proceedings in which we are currently involved, periodically wemay be a party to regulatory proceedings. The results of regulatory proceedings cannot be predicted withcertainty; however, our management believes that we 

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presently do not havematerial potential liability in connection with regulatory proceedings thatwould have a significant financial impact on our consolidated financialcondition, results of operations or cash flows.

A summary of ourcontractual cash obligations as of September 30, 2006, which include expansionprojects on our Badlands, Kinta Area and Bakken gathering systems, is presentedbelow:
| ** **                                | ** ** | **Payment Due by Period** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                | ** ** | **Total**                                | ** ** | **Due in** | ** ** | **Due in** | ** ** | **Due in** | ** ** | **Due in** | ** ** | ** ** | ** ** |
| **Type of Obligation**          | ** ** | **Obligation**                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
| ** **                                | ** ** | **(in thousands)**                  | ** ** |
| Senior secured  revolving credit facility |       | $                                        | 134,064    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 134,064 |   |
| Contracts on internal  expansion projects |       | 11,554                                   |       | 5,111 |   | 6,443 |   | — |   | — |   | — |   |
| Operating leases and  service agreements  |       | 2,693                                    |       | 281 |   | 1,083 |   | 325 |   | 325 |   | 679 |   |
| Total contractual cash obligations        |       | $                                        | 148,311    |   | $ | 5,392 |   | $ | 7,526 |   | $ | 325 |   | $ | 325 |   | $ | 134,743 |   |

 

**Note 8:  SignificantCustomers and Suppliers**

All of our revenuesare domestic revenues. The following table presents our top five midstreamcustomers as a percent of total revenue for the periods indicated:

|            | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** ** | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** ** | ** ** | **2006**                                | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Customer 1 |       | 11                                      | %          | 14                                     | %          | 17 | % | 25 | % |
| Customer 2 |       | 15                                      | %          | —                                 |       | 16 | % | — |   |
| Customer 3 |       | 14                                      | %          | 6                                      | %          | 14 | % | 3 | % |
| Customer 4 |       | 11                                      | %          | 14                                     | %          | 11 | % | 7 | % |
| Customer 5 |       | 17                                      | %          | 12                                     | %          | 12 | % | 19 | % |

 

All of ourpurchases are from domestic sources. The following table presents our top fivemidstream suppliers as a percent of total midstream purchases for the periodsindicated.

|                                  | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                       | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                       | ** ** | **2006**                                | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Supplier 1 (affiliated  company) |       | 33                                      | %          | 34                                     | %          | 34 | % | 33 | % |
| Supplier 2                       |       | 23                                      | %          | 31                                     | %          | 24 | % | 32 | % |
| Supplier 3                       |       | 13                                      | %          | 5                                      | %          | 13 | % | 2 | % |
| Supplier 4                       |       | 5                                       | %          | 11                                     | %          | 7 | % | 13 | % |
| Supplier 5                       |       | 4                                       | %          | 2                                      | %          | 4 | % | 1 | % |

 

**Note 9:  RelatedParty Transactions**

We purchasenatural gas and NGLs from affiliated companies. Purchases of product fromaffiliates totaled $13.1 million and $11.6 million for the threemonths ended September 30, 2006 and 2005, respectively, and $39.6 millionand $26.8 million for the nine months ended September 30, 2006 and 2005,respectively. We also sell natural gas and NGLs to affiliated companies. Salesof product to affiliates totaled $0.9 million and $1.1 million forthe three months ended September 30, 2006 and 2005, respectively, and$3.2 million and $3.5 million for the nine months ended September 30,2006 and 2005, respectively. Compression revenues from affiliates were$1.2 million for each of the three months ended September 30, 2006 and2005 and were $3.6 million and $3.0 million for the nine months endedSeptember 30, 2006 and 2005, respectively.

Accountsreceivable from affiliates of $1,079 at September 30, 2006 includes $928 fromone affiliate for midstream sales. Accounts receivable from affiliates of$1,523 at December 31, 2005 includes $1,451 from the same affiliate formidstream sales.

Accounts payableto affiliates of $4,667 at September 30, 2006 includes $4,399 due to oneaffiliate for midstream purchases. Accounts payable to affiliates of $6,122 atDecember 31, 2005 includes $5,684 payable to the same affiliate formidstream purchases.

We utilizeaffiliated companies to provide services to our plants and pipelines andcertain administrative costs. The total amount 

20

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paid to these companieswas $64 and $15 during the three months ended September 30, 2006 and 2005,respectively, and $180 and $74 during the nine months ended September 30, 2006and 2005, respectively.

We lease officespace under operating leases directly or indirectly from an affiliate. Rentspaid associated with these leases totaled $32 and $19 for the three monthsended September 30, 2006 and 2005, respectively, and totaled $86 and $57 forthe nine months ended September 30, 2006 and 2005, respectively.

**Note 10: Business Segments**

OnFebruary 15, 2005, certain assets and liabilities of Hiland Partners, LLCwere contributed to us in conjunction with our initial public offering. As aresult of this transaction, we have distinct operating segments for whichadditional financial information must be reported. Prior to February 15,2005, we did not have operating segments. Our operations are now classifiedinto two reportable segments:

(1)   Midstream,which is the gathering, compressing, dehydrating, treating and processing ofnatural gas and fractionating NGLs.

(2)   Compression,which is providing air compression and water injection services for CRI’s oiland gas secondary recovery operations that are ongoing in North Dakota.

These operatingsegments reflect the way we manage our operations.  Our operations are conducted in the UnitedStates.  General and administrativecosts, which consist of executive management, accounting and finance,operations and engineering, marketing and business development, are allocatedto the individual business segments based on revenues.

Midstream assetstotaled $296,375 at September 30, 2006. Assets attributable to compressionoperations totaled $32,280. All but $72 of the total additions to property andequipment of $47,989 for the nine months ended September 30, 2006 wasattributable to midstream operations.

The tables belowpresent information for the reportable segments for the three and nine monthsended September 30, 2006 and 2005.
| ** **                                                       | ** ** | **For the Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                                                   | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                              | ** ** | **Compression** | ** ** | **Total** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | **Total** | ** ** |
| Revenues                                                         |       | $                                                                          | 56,062     |   | $ | 1,205 |   | $ | 57,267 |   | $ | 40,720 |   | $ | 1,205 |   | $ | 41,925 |   |
| Operating costs and  expenses:                                   | ** ** | ** **                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Midstream purchases  (exclusive of items shown separately below) |       | 39,609                                                                     |       | — |   | 39,609 |   | 33,313 |   | — |   | 33,313 |   |
| Operations and  maintenance                                      |       | 4,367                                                                      |       | 202 |   | 4,569 |   | 1,744 |   | 153 |   | 1,897 |   |
| Depreciation and  amortization                                   |       | 5,282                                                                      |       | 893 |   | 6,175 |   | 2,024 |   | 888 |   | 2,912 |   |
| General and  administrative expenses                             |       | 1,346                                                                      |       | 29 |   | 1,375 |   | 507 |   | 14 |   | 521 |   |
| Total operating  costs and expenses                              |       | 50,604                                                                     |       | 1,124 |   | 51,728 |   | 37,588 |   | 1,055 |   | 38,643 |   |
| Income from operations                                           |       | $                                                                          | 5,458      |   | $ | 81 |   | 5,539 |   | $ | 3,132 |   | $ | 150 |   | 3,282 |   |
| Other income (expense):                                          | ** ** | ** **                                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest and other  income                                       | ** ** | ** **                                                                 |       |   |   | 68 |   |   |   |   |   | 70 |   |
| Amortization of  deferred loan costs                             | ** ** | ** **                                                                 |       |   |   | (86 | ) |   |   |   |   | (83 | ) |
| Interest expense                                                 | ** ** | ** **                                                                 |       |   |   | (1,783 | ) |   |   |   |   | (585 | ) |
| Total other income  (expense)                                    | ** ** | ** **                                                                 |       |   |   | (1,801 | ) |   |   |   |   | (598 | ) |
| Net income                                                       | ** ** | ** **                                                                 |       |   |   | $ | 3,738 |   |   |   |   |   | $ | 2,684 |   |

 

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| ** **                                                       | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                             | ** ** | **Compression** | ** ** | **Total** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | **Total** | ** ** |
| Revenues                                                         |       | $                                                                         | 159,800    |   | $ | 3,615 |   | $ | 163,415 |   | $ | 95,294 |   | $ | 3,012 |   | $ | 98,306 |   |
| Operating costs and  expenses:                                   | ** ** | ** **                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Midstream purchases  (exclusive of items shown separately below) |       | 117,965                                                                   | ** ** | ** ** |   | 117,965 |   | 77,548 |   | — |   | 77,548 |   |
| Operations and  maintenance                                      |       | 10,509                                                                    |       | 631 |   | 11,140 |   | 4,712 |   | 371 |   | 5,083 |   |
| Depreciation and amortization                                    |       | 13,132                                                                    |       | 2,679 |   | 15,811 |   | 4,697 |   | 2,227 |   | 6,924 |   |
| General and  administrative expenses                             |       | 3,572                                                                     |       | 81 |   | 3,653 |   | 1,492 |   | 47 |   | 1,539 |   |
| Total operating  costs and expenses                              |       | 145,178                                                                   |       | 3,391 |   | 148,569 |   | 88,449 |   | 2,645 |   | 91,094 |   |
| Income from operations                                           |       | $                                                                         | 14,622     |   | $ | 224 |   | 14,846 |   | $ | 6,845 |   | $ | 367 |   | 7,212 |   |
| Other income (expense):                                          | ** ** | ** **                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest and other  income                                       | ** ** | ** **                                                                |       |   |   | 222 |   |   |   |   |   | 112 |   |
| Amortization of  deferred loan costs                             | ** ** | ** **                                                                |       |   |   | (319 | ) |   |   |   |   | (360 | ) |
| Interest expense                                                 | ** ** | ** **                                                                |       |   |   | (3,643 | ) |   |   |   |   | (766 | ) |
| Total other income  (expense)                                    | ** ** | ** **                                                                |       |   |   | (3,740 | ) |   |   |   |   | (1,014 | ) |
| Net income                                                       | ** ** | ** **                                                                |       |   |   | $ | 11,106 |   |   |   |   |   | $ | 6,198 |   |

 

**Note 11: Net Income per Limited Partner Unit**

The computation ofbasic net income per limited partner unit is based on the weighted-averagenumber of common and subordinated units outstanding during the period.  Thecomputation of diluted earnings per unit further assumes the dilutive effect ofunit options and restricted units. Net income per unit applicable to limited partners is computed bydividing net income applicable to limited partners, after deducting the generalpartner’s 2% interest and incentive distributions, and after deducting netincome attributable to the Predecessor (before February 15, 2005), by theweighted-average number of limited partnership units outstanding. The followingis a reconciliation of the limited partner units used in the calculations ofincome per limited partner unit — basic and income per limited partnerunit — diluted assuming dilution for the three month and nine monthperiods ended September 30, 2006 and 2005:
| ** **                                                      | ** ** | **For the Three Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                                                   | ** ** | **2005** | ** ** |
| ** **                                                      | ** ** | **Income  Available to  Limited  Partners  (Numerator)**              | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** | **Income  Available to  Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** |
| ** **                                                      | ** ** | ** **                                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income per limited  partner unit -basic:                        |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Income available to  limited unitholders                        |       | $                                                                          | 3,026      |   |   |   | $ | 0.33 |   | $ | 2,617 |   |   |   | $ | 0.38 |   |
| Weighted average  limited partner units outstanding             |       |                                                                       |       | 9,237,000 |   |   |   |   |   | 6,800,000 |   |   |   |
| Income per limited  partner unit — diluted:                |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Unit Options                                                    |       |                                                                       |       | 49,000 |   |   |   |   |   | 44,000 |   |   |   |
| Income available to common unitholders plus assumed conversions |       | $                                                                          | 3,026      |   | 9,286,000 |   | $ | 0.33 |   | $ | 2,617 |   | 6,844,000 |   | $ | 0.38 |   |

 

22

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| ** **                                                       | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **Income  Available to  Limited  Partners  (Numerator)**             | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** | **Income  Available to  Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** |
| ** **                                                       | ** ** | ** **                                                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income per limited  partner unit -basic:                         |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Income available to  limited unitholders                         |       | $                                                                         | 9,517      |   |   |   | $ | 1.07 |   | $ | 5,577 |   |   |   | $ | 0.82 |   |
| Weighted average  limited partner units outstanding              |       |                                                                      |       | 8,867,000 |   |   |   |   |   | 6,800,000 |   |   |   |
| Income per limited  partner unit — diluted:                 |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Unit Options                                                     |       |                                                                      |       | 46,000 |   |   |   |   |   | 30,000 |   |   |   |
| Income available to  common unitholders plus assumed conversions |       | $                                                                         | 9,517      |   | 8,913,000 |   | $ | 1.07 |   | $ | 5,577 |   | 6,830,000 |   | $ | 0.82 |   |

 

**Note 12:  Partners’Capital and Cash Distributions**

Our unitholders(limited partners) have only limited voting rights on matters affecting ouroperations and activities and, therefore, limited ability to influence ourmanagement’s decisions regarding our business. Unitholders did not select ourgeneral partner or elect the board of directors of our general partner andeffectively have no right to select our general partner or elect its board ofdirectors in the future. Unitholders’ voting rights are further restricted byour partnership agreement provision providing that any units held by a personthat owns 20% or more of any class of units then outstanding, other than thegeneral partner, its affiliates, their transferees and persons who acquiredsuch units with the prior approval of the board of directors of our generalpartner, cannot be voted on any matter. In addition, our partnership agreementcontains provisions limiting the ability of our unitholders to call meetings orto acquire information about our operations, as well as other provisionslimiting a unitholders’ ability to influence the manner or direction of ourmanagement.

Our PartnershipAgreement requires that we distribute all of our cash on hand at the end ofeach quarter, less reserves established at our general partner’s discretion. Werefer to this as “available cash.” The amount of available cash may be greaterthan or less than the minimum quarterly distributions. In general, we will payany cash distribution made each quarter in the following manner:

·                  first, 98% tothe common units and 2% to our general partner, until each common unit hasreceived a minimum quarterly distribution of $0.45 plus any arrearages fromprior quarters;

·                  second, 98% tothe subordinated units and 2% to our general partner, until each subordinatedunit has received a minimum quarterly distribution of $0.45; and

·                  third, 98% toall units pro rata, and 2% to our general partner, until each unit has receiveda distribution of $0.495.

If cashdistributions per unit exceed $0.495 in any quarter, our general partner willreceive increasing percentages, up to a maximum of 50% of the cash wedistribute in excess of that amount. We refer to these distributions as “incentivedistributions.”

The distributionson the subordinated units may be reduced or eliminated if necessary to ensurethe common units receive their minimum quarterly distribution. Subordinatedunits will not accrue arrearages. The subordination period will end once wemeet certain financial tests, but not before March 31, 2010. These financialtests require us to have earned and paid the minimum quarterly distribution onall of our outstanding units for three consecutive four-quarter periods. Whenthe subordination period ends, all remaining subordinated units will convertinto common units on a one-for-one basis, and the common units will no longerbe entitled to arrearages.

All distributionspaid by us to common and subordinated unitholders, including amounts paid toaffiliate owners and regular and incentive distributions paid to our generalpartner were as follows (in thousands, except per unit amounts):

23

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| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|--------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
| 05/13/05           |       | $                           | 0.2250     |       | $          | 612              |       | $                        | 918        |                | $          | 31               |       | $ | — |   | $ | 1,561 |   |
| 08/12/05           |       | 0.4625                      |       | 1,258      |       | 1,887            |       | 64                       |       | —              |       | 3,209            |       |
| 11/14/05           |       | 0.5125                      |       | 1,398      |       | 2,091            |       | 72                       |       | 18                  |       | 3,579            |       |
| 02/14/06           |       | 0.6250                      |       | 2,724      |       | 2,550            |       | 112                      |       | 249                 |       | 5,635            |       |
| 05/15/06           |       | 0.6500                      |       | 2,858      |       | 2,652            |       | 119                      |       | 315                 |       | 5,944            |       |
| 08/14/06           |       | 0.6750                      |       | 3,485      |       | 2,754            |       | 136                      |       | 414                 |       | 6,789            |       |
| 11/14/06 (a)       |       | 0.7000                      |       | 3,623      |       | 2,856            |       | 145                      |       | 637                 |       | 7,261            |       |
|               |       | $                           | 3.8500     |       | $          | 15,958           |       | $                        | 15,708     |                | $          | 679              |       | $ | 1,633 |   | $ | 33,978 |   |

----

(a) This cashdistribution was announced on October 24, 2006 and will be paid on November 14,2006 to all unitholders of record as of November 6, 2006.

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**HILANDPARTNERS, LP**

**Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

**CautionaryStatement About Forward-Looking Statements**

This QuarterlyReport on Form 10-Q includes certain “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934.  These statements includestatements regarding our plans, goals, beliefs or current expectations.Statements using words such as “anticipate,” “believe,” “intend,” “project,” “plan,”“continue,” “estimate,” “forecast,” “may,” “will,” or similar expressions helpidentify forward-looking statements.  Although we believe suchforward-looking statements are based on reasonable assumptions and currentexpectations and projections about future events, no assurance can be giventhat every objective will be reached.

Our actual resultsmay differ materially from any results projected, forecasted, estimated orexpressed in forward-looking statements since many of the factors thatdetermine these results are subject to uncertainties and risks, difficult topredict, and beyond management’s control.  Such factors include:

·            the general economic conditions in theUnited States of America as well as the general economic conditions andcurrencies in foreign countries;

·            thecontinued ability to find and contract for new sources of natural gas supply;

·            theamount of natural gas transported on our gathering systems;

·            thelevel of throughput in our natural gas processing and treating facilities;

·            thefees we charge and the margins realized for our services;

·            theprices and market demand for, and the relationship between, natural gas andNGLs;

·            energyprices generally;

·            thelevel of domestic oil and natural gas production;

·            theavailability of imported oil and natural gas;

·            actionstaken by foreign oil and gas producing nations;

·            the political andeconomic stability of petroleum producing nations;

·            the weather in ouroperating areas;

·            the extent of governmentalregulation and taxation;

·            hazards or operatingrisks incidental to the transporting, treating and processing of natural gasand NGLs that may not be fully covered by insurance;

·            competition from othermidstream companies;

·            loss of key personnel;

·            the availability andcost of capital and our ability to access certain capital sources;

·            changes in laws andregulations to which we are subject, including tax, environmental,transportation and employment regulations;

·            the costs and effectsof legal and administrative proceedings;

·            the ability tosuccessfully identify and consummate strategic acquisitions at purchase pricesthat are accretive to our financial results; and

25

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·            risksassociated with the construction of new pipelines and treating and processingfacilities or additions to our existing pipelines and facilities.

These factors arenot necessarily all of the important factors that could cause our actualresults to differ materially from those expressed in any of our forward-lookingstatements.  Our future results will depend upon various other risks anduncertainties, including, but not limited to those described above.  Otherunknown or unpredictable factors also could have material adverse effects onour future results.  You should not place undue reliance on anyforward-looking statements.

Allforward-looking statements attributable to us are qualified in their entiretyby this cautionary statement.   We undertake no duty to update ourforward-looking statements to reflect the impact of events or circumstancesafter the date of the forward-looking statements.

**OVERVIEW**

We are a Delawarelimited partnership formed in October 2004 to own and operate the assetsthat had historically been owned and operated by Continental Gas, Inc. (“CGI”)and Hiland Partners, LLC.

CGI historicallyowned all of our natural gas gathering, processing, treating and fractionationassets other than our Worland and Bakken gathering systems. Hiland Partners,LLC historically owned our Worland gathering system, our compression servicesassets and the Bakken gathering system and certain systems acquired orconstructed since our formation. CGI is our predecessor for accountingpurposes. As a result, our historical financial statements for periods prior toFebruary 15, 2005 are the financial statements of CGI.

In connection withour initial public offering, the former owners of CGI and Hiland Partners, LLCand certain of our affiliates, including our general partner, contributed tous, all of the assets and operations of CGI, other than a portion of itsworking capital assets, and substantially all of the assets and operations ofHiland Partners, LLC, other than a portion of its working capital assets andthe assets related to the Bakken gathering system, in exchange for an aggregateof 720,000 common units and 4,080,000 subordinated units, a 2% general partnerinterest in us and all of our incentive distribution rights, which entitle thegeneral partner to increasing percentages of the cash we distribute in excessof $0.495 per unit per quarter.

We completed ourinitial public offering of 2,300,000 common units on February 15, 2005,receiving net proceeds of $48.1 million. The proceeds from the publicoffering were used to (1) pay remaining offering costs of$2.2 million and deferred debt issuance costs of $0.6 million, (2)pay outstanding indebtedness of $22.9 million, (3) redeem$6.3 million of common units from an affiliate of Harold Hamm and the HammTrusts, and (4) make a $3.9 million distribution to the previous owners ofHiland Partners, LLC. We retained $12.2 million to replenish workingcapital.

EffectiveSeptember 1, 2005, we consummated the Bakken acquisition pursuant to whichwe acquired Hiland Partners, LLC, an Oklahoma limited liability company, forapproximately $92.7 million in cash, $35.0 million of which was usedto retire outstanding Hiland Partners, LLC indebtedness. At the time of thisacquisition, Hiland Partners, LLC’s principal asset was the Bakken gatheringsystem located in eastern Montana.

We completed afollow-on public offering of 1,630,000 common units on November 21, 2005,receiving net proceeds of $66.1 million, including our general partner’scontribution of $1.4 million to maintain its 2.0% interest in us.  We used $65.2 million of the proceeds fromthe public offering to repay a portion of credit facility borrowings we hadpreviously used to fund the acquisition of Hiland Partners, LLC.

On May 1, 2006, weacquired Enogex Gas Gathering, L.L.C.’s eastern Oklahoma Kinta Area gatheringassets for $96.4 million.  We financedthe acquisition with $61.2 million of borrowings from our credit facility and$35.0 million of proceeds from the issuance to our general partner of 761,714common units and 15,545 general partner equivalent units at $45.03 per unit.

On September 25,2006, certain affiliated unitholders contributed (i) all of the membershipinterests in our general partner, which owns the 2% general partner interestand all of the incentive distribution rights in us and (ii) a 57.0% limitedpartner interest in us (including 761,714 common units held by our generalpartner) to Hiland Holdings GP, LP, a publicly owned limited partnership (NASDAQ: HPGP), in exchange for 13,550,000 limitedpartner units, representing a 62.7% ownership in Hiland Holdings GP, LP.  HilandPartners GP Holdings, LLC, a Delaware limited liability company formed on May10, 2006, is the general partner of Hiland Holdings GP, LP.

We are engaged ingathering, compressing, dehydrating, treating, processing and marketing naturalgas, fractionating NGLs and providing air compression and water injectionservices for oil and gas secondary recovery operations. Our operations areprimarily located in the Mid-Continent and Rocky Mountain regions of the UnitedStates.

We manage ourbusiness and analyze and report our results of operations on a segmentbasis.  Our operations are divided into two 

26

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business segments:

·                    *Midstream Segment*, which is engaged ingathering and processing of natural gas primarily in the Mid-Continent andRocky Mountain regions.  Within this segment, we also provide certainrelated services for compression, dehydration, and treatment of natural gas andthe fractionation of NGLs.  This segment generated approximately 93% and86% of our total segment margin for the three months ended September 30, 2006and 2005, respectively, and 92% and 85% of our total segment margin for thenine months ended September 30, 2006 and 2005, respectively.

·                    *Compression Segment*, which is engaged inproviding air compression and water injection services for oil and gassecondary recovery operations that are ongoing in North Dakota.  For thethree months ended September 30, 2006 and 2005, this segment generatedapproximately 7% and 14% of our total segment margin, respectively.  For the nine months ended September 30, 2006and 2005, this segment generated approximately 8% and 15% of our total segmentmargin, respectively.

Our midstreamassets consist of thirteen natural gas gathering systems with approximately1,800 miles of gas gathering pipelines, five natural gas processingplants, three natural gas treating facilities and three NGL fractionationfacilities. Our compression assets consist of two air compression facilitiesand a water injection plant.

The financialstatements and financial information for the nine month period ended September30, 2005 reflect the operations of CGI, our predecessor prior to February 15,2005 and our operations from February 15, 2005, the date of our initial publicoffering.

***Historical Results of Operations***

Our historicalresults of operations for the periods presented may not be comparable, eitherfrom period to period or going forward, for the reasons described below:

·                    The assets ofCGI (Predecessor) were transferred to us at historical cost as it is considereda reorganization of entities under common control.  Accordingly, ourhistorical financial statements for the periods prior to February 15, 2005 arethe financial statements of CGI.

·                    Ouracquisition of certain net assets from Hiland Partners, LLC in connection withour initial public offering was accounted for as a purchase and, as a result,these assets are recorded at their fair value at the time of purchase, whichoccurred concurrent with the closing of our initial public offering on February15, 2005.  Therefore, the results of operations from our Worland gatheringsystem and compression assets are only reflected from February 15, 2005, thedate of our initial public offering.

·                    As statedabove, prior to our formation, Hiland Partners, LLC owned our Horse Creek aircompression and our Cedar Hills water injection facility.  These assetshave historically been under a lease agreement with Continental Resources,Inc.  In connection with our formation and our initial public offering, weentered into a four-year services agreement with Continental Resources, Inc.,effective as of January 28, 2005, that replaced the existing lease.  Underthe services agreement, we own and operate the facilities and provide aircompression and water injection services to Continental Resources, Inc. for afee.

·                    Ouracquisition of Hiland Partners, LLC on September 26, 2005 was accounted for asa purchase except as described below.   As a result of 49% of theoutstanding membership interests of Hiland Partners, LLC being partially ownedby an affiliate, who at the time, was a controlling member of our generalpartner, 49% of the net assets of Hiland Partners, LLC, for which estimatedfair value was in excess of historical basis, have been recorded at historicalcost and 51% of the assets have been recorded at fair value.  The resultsof operations from our Bakken gathering system, the primary assetof Hiland Partners, LLC at the time of this acquisition, are onlyreflected from September 1, 2005, our effective acquisition date.

·                    Ouracquisition of the Kinta Area gathering assets from Enogex Gas Gathering,L.L.C. on May 1, 2006 was accounted for as a purchase of assets.  Results of operations from our Kinta Areagathering assets are only reflected from May 1, 2006.

**Resultsof Operations**

Set forth in thetables below are financial and operating data for our predecessor, CGI, and usfor the periods indicated. Operations from our Worland gathering system andcompression assets contributed to us by Hiland Partners, LLC are reflected onlyfrom February 15, 2005, the date of our initial public offering.  Operations from our acquisition of the Bakkengathering system assets are reflected only from September 1, 2005.  Operations from our acquisition of the KintaArea gathering assets are reflected only from May 1, 2006.

27

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| ** **                                                       | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**                                  | ** ** |
| **Total Segment Margin Data:**                                   | ** ** | ** **                                               | ** ** | ** ** | ** ** |
| Midstream revenues                                               |       | $                                                        | 56,062     |   | $ | 40,720 |   |
| Midstream purchases                                              |       | 39,609                                                   |       | 33,313 |   |
| Midstream segment  margin                                        |       | 16,453                                                   |       | 7,407 |   |
| Compression revenues  (1)                                        |       | 1,205                                                    |       | 1,205 |   |
| Total segment margin  (2)                                        |       | $                                                        | 17,658     |   | $ | 8,612 |   |
|                                                             |       |                                                     |       |   |   |
| **Summary of Operations Data:**                                  | ** ** | ** **                                               | ** ** | ** ** | ** ** |
| Midstream revenues                                               |       | $                                                        | 56,062     |   | $ | 40,720 |   |
| Compression revenues                                             |       | 1,205                                                    |       | 1,205 |   |
| Total revenues                                                   |       | 57,267                                                   |       | 41,925 |   |
|                                                             |       |                                                     |       |   |   |
| Midstream purchases  (exclusive of items shown separately below) |       | 39,609                                                   |       | 33,313 |   |
| Operations and  maintenance                                      |       | 4,569                                                    |       | 1,897 |   |
| Depreciation,  amortization and accretion                        |       | 6,175                                                    |       | 2,912 |   |
| General and  administrative                                      |       | 1,375                                                    |       | 521 |   |
| Total operating costs  and expenses                              |       | 51,728                                                   |       | 38,643 |   |
| Operating income                                                 |       | 5,539                                                    |       | 3,282 |   |
| Other income (expense)                                           |       | (1,801                                                   | )          | (598 | ) |
| **Net income**                                                   |       | 3,738                                                    |       | 2,684 |   |
|                                                             |       |                                                     |       |   |   |
| Add:                                                             |       |                                                     |       |   |   |
| Depreciation,  amortization and accretion                        |       | 6,175                                                    |       | 2,912 |   |
| Amortization of  deferred loan costs                             |       | 86                                                       |       | 83 |   |
| Interest expense                                                 |       | 1,783                                                    |       | 585 |   |
|                                                             |       |                                                     |       |   |   |
| **EBITDA**(3)                                                    |       | $                                                        | 11,782     |   | $ | 6,264 |   |
|                                                             |       |                                                     |       |   |   |
| Operating Data:                                                  |       |                                                     |       |   |   |
| Natural gas sales  (MMBTU/d)                                     |       | 69,563                                                   |       | 46,815 |   |
| NGL sales (Bbls/d)                                               |       | 3,239                                                    |       | 1,911 |   |
| Natural gas gathered  (MMBtu/d) (4)                              |       | 129,168                                                  |       | — |   |
|                                                             |       |                                                     |       |   |   |

 

28

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| ** **                                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                       | ** ** | ** **                                              | ** ** | **2005** | ** ** |
| ** **                                                       | ** ** | **2006**                                                | ** ** | **Hiland  Partners,  LP (5)** | ** ** | **Continental  Gas, Inc.  (Predecessor) (6)** | ** ** | **Total (7)** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**                                 | ** ** |
| **Total Segment Margin Data:**                                   |       |                                                    |       |   |   |   |   |   |   |
| Midstream revenues                                               |       | $                                                       | 159,800    |   | $ | 83,481 |   | $ | 11,813 |   | $ | 95,294 |   |
| Midstream purchases                                              |       | 117,965                                                 |       | 67,801 |   | 9,747 |   | 77,548 |   |
| Midstream segment margin                                         |       | 41,835                                                  |       | 15,680 |   | 2,066 |   | 17,746 |   |
| Compression revenues  (1)                                        |       | 3,615                                                   |       | 3,012 |   | — |   | 3,012 |   |
| Total segment margin  (2)                                        |       | $                                                       | 45,450     |   | $ | 18,692 |   | $ | 2,066 |   | $ | 20,758 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| **Summary of Operations Data:**                                  | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream revenues                                               |       | $                                                       | 159,800    |   | $ | 83,481 |   | $ | 11,813 |   | $ | 95,294 |   |
| Compression revenues                                             |       | 3,615                                                   |       | 3,012 |   | — |   | 3,012 |   |
| Total revenues                                                   |       | 163,415                                                 |       | 86,493 |   | 11,813 |   | 98,306 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| Midstream purchases  (exclusive of items shown separately below) |       | 117,965                                                 |       | 67,801 |   | 9,747 |   | 77,548 |   |
| Operations and  maintenance                                      |       | 11,140                                                  |       | 4,303 |   | 780 |   | 5,083 |   |
| Depreciation,  amortization and accretion                        |       | 15,811                                                  |       | 6,412 |   | 512 |   | 6,924 |   |
| General and  administrative                                      |       | 3,653                                                   |       | 1,373 |   | 166 |   | 1,539 |   |
| Total operating costs  and expenses                              |       | 148,569                                                 |       | 79,889 |   | 11,205 |   | 91,094 |   |
| Operating income                                                 |       | 14,846                                                  |       | 6,604 |   | 608 |   | 7,212 |   |
| Other income (expense)                                           |       | (3,740                                                  | )          | (899 | ) | (115 | ) | (1,014 | ) |
| **Net income**                                                   |       | 11,106                                                  |       | 5,705 |   | 493 |   | 6,198 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| Add:                                                             |       |                                                    |       |   |   |   |   |   |   |
| Depreciation,  amortization and accretion                        |       | 15,811                                                  |       | 6,412 |   | 512 |   | 6,924 |   |
| Amortization of  deferred loan costs                             |       | 319                                                     |       | 347 |   | 13 |   | 360 |   |
| Interest expense                                                 |       | 3,643                                                   |       | 658 |   | 108 |   | 766 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| **EBITDA**(3)                                                    |       | $                                                       | 30,879     |   | $ | 13,122 |   | $ | 1,126 |   | $ | 14,248 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| Operating Data:                                                  |       |                                                    |       |   |   |   |   |   |   |
| Natural gas sales  (MMBTU/d)                                     |       | 64,796                                                  |       | 44,226 |   | 37,052 |   | 43,044 |   |
| NGL sales (Bbls/d)                                               |       | 3,256                                                   |       | 1,631 |   | 1,206 |   | 1,561 |   |
| Natural gas gathered  (MMBtu/d) (4)                              |       | 72,657                                                  |       | — |   | — |   | — |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |

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(1) Compressionrevenues and compression segment margin are the same. There are no compressionpurchases associated with the compression segment.

(2) Reconciliationof total segment margin to operating income:

 

|                                                                        | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**                                  | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Income (Loss)** |       |                                                     |       |   |   |
| Operating income                                                       |       | $                                                        | 5,539      |   | $ | 3,282 |   |
| Add:                                                                   |       |                                                     |       |   |   |
| Operations and  maintenance expenses                                   |       | 4,569                                                    |       | 1,897 |   |
| Depreciation,  amortization and accretion                              |       | 6,175                                                    |       | 2,912 |   |
| General and  administrative expenses                                   |       | 1,375                                                    |       | 521 |   |
| Total segment  margin                                                  |       | $                                                        | 17,658     |   | $ | 8,612 |   |

 

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| ** **                                                             | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                             | ** ** | ** **                                              | ** ** | **2005** | ** ** |
| ** **                                                             | ** ** | **2006**                                                | ** ** | **Hiland  Partners,  LP (5)** | ** ** | **Continental  Gas, Inc.  (Predecessor) (6)** | ** ** | **Total (7)** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**                                      | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Income (Loss)** |       |                                                    |       |   |   |   |   |   |   |
| Operating income                                                       |       | $                                                       | 14,846     |   | $ | 6,604 |   | $ | 608 |   | $ | 7,212 |   |
| Add:                                                                   |       |                                                    |       |   |   |   |   |   |   |
| Operations and  maintenance expenses                                   |       | 11,140                                                  |       | 4,303 |   | 780 |   | 5,083 |   |
| Depreciation,  amortization and accretion                              |       | 15,811                                                  |       | 6,412 |   | 512 |   | 6,924 |   |
| General and  administrative expenses                                   |       | 3,653                                                   |       | 1,373 |   | 166 |   | 1,539 |   |
| Total segment  margin                                                  |       | $                                                       | 45,450     |   | $ | 18,692 |   | $ | 2,066 |   | $ | 20,758 |   |

 

We view totalsegment margin, a non-GAAP financial measure, as an important performancemeasure of the core profitability of our operations. We continually reviewtotal segment margin for consistency and trend analysis. We define midstreamsegment margin as midstream revenue less midstream purchases. Midstreampurchases include the following costs and expenses: cost of natural gas andNGLs purchased by us from third parties, cost of natural gas and NGLs purchasedby us from affiliates, and the cost of crude oil purchased by us from third parties.We define compression segment margin as the revenue derived from ourcompression segment.

(3) We defineEBITDA, a non-GAAP financial measure, as net income plus interest expense,provisions for income taxes and depreciation, amortization and accretionexpense. EBITDA is used as a supplemental financial measure by our managementand by external users of our financial statements such as investors, commercialbanks, research analysts and others to assess: (1) the financial performance ofour assets without regard to financial methods, capital structure or historicalcost basis; (2) the ability of our assets to generate cash sufficient to payinterest costs and support our indebtedness; (3) our operating performance andreturn on capital as compared to those of other companies in the midstreamenergy sector, without regard to financing or structure; and (4) the viabilityof acquisitions and capital expenditure projects and the overall rates ofreturn on alternative investment opportunities. EBITDA is also a financialmeasurement that, with certain negotiated adjustments, is reported to our banksand is used as a gauge for compliance with our financial covenants under ourcredit facility. EBITDA should not be considered an alternative to netincome, operating income, cash flows from operating activities or any othermeasure of financial performance presented in accordance with GAAP.  OurEBITDA may not be comparable to EBITDA of similarly titled measures of otherentities, as other entities may not calculate EBITDA in the same manner as wedo.

(4) Natural gasgathered for fee (MMBtu/d) represents natural gas volumes gathered associatedwith the Kinta Area gathering assets we acquired on May 1, 2006 in which we donot take title to the gas.

(5) Amountspresented in the Hiland Partners, LP column include only the activity for theperiod beginning on February 15, 2005.  These amounts include theoperations of the Worland gathering system and compression assets acquired fromHiland Partners, LLC at the completion of our initial public offering.

(6) Amountspresented in the Predecessor columns include only the operations of CGI for theperiod prior to our initial public offering on February 15, 2005.

(7) Totalincome and expense items included in our Consolidated Statements of Operationsand our predecessor are included in this Form 10-Q for the stated period.

**ThreeMonths Ended September 30, 2006 Compared with Three Months Ended September 30,2005**

***Revenues.***  Total revenues(midstream and compression) were $57.3 million for the three months endedSeptember 30, 2006 compared to $41.9 million for the three months endedSeptember 30, 2005, an increase of $15.4 million, or 36.6%.  This increasewas primarily attributable to (i) increased volumes of approximately 13,230 MMBtu/d(MMBtu per day) of natural gas sales and 1,250 Bbls/d (Bbls per day) of NGLsales attributable to our acquisition of the Bakken gathering system effectiveSeptember 1, 2005 and (ii) increased volumes of approximately 8,380 MMBtu/d ofnatural gas sales and 129,168 MMbtu/d of natural gas gathered from the KintaArea gathering assets we acquired on May 1, 2006.

Midstream revenueswere $56.1 million for the three months ended September 30, 2006 compared to$40.7 million for the three months ended September 30, 2005, an increase of$15.4 million, or 37.7%. Of this increase, $18.7 million was primarilyattributable to higher residue natural gas sales volumes and $6.9 million wasattributable to higher NGL sales volumes. The midstream revenues attributable tothe increase in natural gas sales volumes were offset by a 17.9% decline inaverage realized natural gas sales prices, or 

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$10.2 million.  The volume increases are primarilyattributable to the Bakken gathering system we acquired effective September 1, 2005and the Kinta Area gathering assets we acquired on May 1, 2006.

Natural gas salesvolumes were 69,563 MMBtu/d for the three months ended September 30, 2006compared to 46,815 MMBtu/d for the three months ended September 30, 2005, anincrease of 22,748 MMBtu/d, or 48.6%.  Of the 22,748 MMBtu/d increase,13,233 MMBtu/d (58.2%) was attributable to natural gas volumes as a result ofour Bakken gathering system acquisition effective September 1, 2005 and 8,381MMBtu/d (36.8%) was attributable to natural gas volumes as a result of ourKinta Area gathering assets we acquired on May 1, 2006. Our NGL sales volumeswere 3,239 Bbls/d for the three months ended September 30, 2006 compared to1,911 Bbls/d for the three months ended September 30, 2005, an increase of1,328 Bbls/d, or 69.5%.  Of the 1,328 Bbls/d increase, 1,259 Bbls/d(94.8%) was attributable to our Bakken gathering system.

Average realizednatural gas sales prices were $5.98 per MMBtu for the three months endedSeptember 30, 2006 compared to $7.28 per MMBtu for the three months endedSeptember 30, 2005, a decrease of $1.30 per MMBtu, or 17.9%.  Averagerealized NGL sales prices were $1.09 per gallon for both of the three monthsended September 30, 2006 and 2005. The decrease in natural gas prices was primarilydue to a softening of supply and demand fundamentals for natural gas, whichcaused natural gas prices to fall during the three months ended September 30,2006 compared to the three months ended September 30, 2005.

Cash received fromour counterparty on cash flow swap contracts for natural gas derivativetransactions that closed during the three months ended September 30, 2006totaled $1.4 million.  This gainincreased average realized natural gas sales prices to $5.98 per MMBtu from$5.76 per MMBtu, an increase of $0.22 per MMBtu, (3.8%).  We had no derivative transactions during thethree months ended September 30, 2005.

Fees earned from129,168 MMBtu/d of natural gas gathered, in which we do not take title to thegas, related to our Kinta Area gathering assets were $2.7 million for the threemonths ended September 30, 2006.  We hadno similar fees from natural gas gathering during the three months endedSeptember 30, 2005.

Compressionrevenues were $1.2 million for the each of the three months ended September 30,2006 and 2005.

***Midstream Purchases.***  Midstreampurchases were $39.6 million for the three months ended September 30, 2006compared to $33.3 million for the three months ended September 30, 2005, a netincrease of $6.3 million, or 18.9%.  The net increase of $6.3 million wasattributable to a $7.6 million increase in purchases as a result of our Bakkengathering system acquisition effective September 1, 2005 and a $3.3 millionincrease was attributable to purchases as a result of our Kinta Area gatheringassets we acquired on May 1, 2006, both of which were offset by the effect ofreduced realized natural gas sales prices of $4.6 million.

***Operations and Maintenance.*** Operations and maintenance expense totaled $4.6 million for the three months endedSeptember 30, 2006 compared with $1.9 million for the three months endedSeptember 30, 2005, an increase of $2.7 million, or 140.9%. Of this increase,$1.7 million, or 63.7% was attributable to operations and maintenance as aresult of our Kinta Area gathering assets we acquired on May 1, 2006 and $0.6million, or 23.9% was attributable to operations and maintenance at our Bakkengathering system we acquired effective September 1, 2005.

***Depreciation, Amortization and Accretion.*** Depreciation, amortization and accretion expense totaled $6.2 million for thethree months ended September 30, 2006 compared with $2.9 million for the threemonths ended September 30, 2005, an increase of $3.3 million, or 112.1%. Of this increase, $2.0 million, or 60.3% was attributable to depreciation andamortization on our Kinta Area gathering assets we acquired on May 1, 2006 and$1.2 million, or 36.0% was attributable to depreciation and amortization on ourBakken gathering system we acquired effective September 1, 2005.

***General and Administrative.*** General and administrative expense totaled $1.4 million for the three monthsended September 30, 2006 compared with $0.5 million for the three months endedSeptember 30, 2005, an increase of $0.9 million, or 163.9%.  The increaseis primarily attributable to increased salaries and additional staffing of $0.3million as a result of growth and $0.3 million in Sarbanes-Oxley internalcontrol compliance costs and audit and tax preparation fees.

***Other Income (Expense).*** Otherincome (expense) totaled ($1.8) million for the three months ended September30, 2006 compared with ($0.6) million for the three months ended September 30,2005, an increase in expense of $1.2 million.  The increase is primarilyattributable to interest expense associated with borrowings of $61.2 million onour credit facility to partially finance the Kinta Area gathering assets weacquired on May 1, 2006 and the interest expense associated with the partialfinancing of the acquisition of the Bakken gathering system effective September1, 2005.

**NineMonths Ended September 30, 2006 Compared with Nine Months Ended September 30,2005**

***Revenues.***  Total revenues(midstream and compression) were $163.4 million for the nine months endedSeptember 30, 2006 compared to $98.3 million for the nine months endedSeptember 30, 2005, an increase of $65.1 million, or 66.2%.  This increasewas primarily attributable to (i) increased volumes of approximately 14,200MMBtu/d of natural gas sales, and 1,600 Bbls/d of NGL sales attributable to ouracquisition of the Bakken gathering system effective September 1, 2005, (ii)increased volumes of approximately 

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7,597 MMBtu/d of naturalgas sales and 129,644 MMBtu/d of natural gas gathered for the five months endedSeptember 30, 2006 from the Kinta Area gathering assets we acquired on May 1,2006 (iii) additional volumes attributable to the Worland gathering systemwhich was contributed to us on February 15, 2005 and (iv) increased revenuesfrom compression assets also contributed to us on February 15, 2005.

Midstream revenueswere $159.8 million for the nine months ended September 30, 2006 compared to$95.3 million for the nine months ended September 30, 2005, an increase of$64.5 million, or 67.7%. Of this increase, $61.0 million was primarily attributableto higher residue natural gas and NGL sales volumes and $3.5 million wasattributable to higher NGL sales prices offset by a slight decrease in averagerealized natural gas prices. The Bakken gathering system we acquired effectiveSeptember 1, 2005 represented $43.3 million, or 67.2% of the volume increasewhile the increase in volumes attributable to the Kinta Area gathering assetswe acquired on May 1, 2006 represented $11.8 million, or 18.2%. The inclusionof Worland gathering system for the entire nine months in 2006 as compared toonly seven and one-half months of the corresponding period in 2005 alsocontributed to the volume increase for the nine months ended September 30, 2006as compared to the corresponding period in 2005.

Natural gas salesvolumes were 64,796 MMBtu/d for the nine months ended September 30, 2006compared to 43,044 MMBtu/d for the nine months ended September 30, 2005, anincrease of 21,752 MMBtu/d, or 50.5%.  Of the 21,752 MMBtu/d increase,14,178 MMBtu/d, or 65.2% was attributable to the natural gas volumes as aresult of our Bakken gathering system acquisition effective September 1, 2005and 7,597 MMBtu/d, or 34.9% was attributable to the natural gas volumes as aresult of our Kinta Area gathering assets we acquired on May 1, 2006. Our NGLsales volumes were 3,256 Bbls/d for the nine months ended September 30, 2006compared to 1,561 Bbls/d for the nine months ended September 30, 2005, anincrease of 1,695 Bbls/d, or 108.6%.  Of the 1,695 Bbls/d increase, 1,599,or 94.3% was attributable to our Bakken gathering system. These increases involumes were also attributable in part to the inclusion of the Worlandgathering system for the entire nine months in 2006 as compared to only sevenand one-half months of the corresponding period in 2005.

Average realizednatural gas sales prices were $6.30 per MMBtu for the nine months endedSeptember 30, 2006 compared to $6.35 per MMBtu for the nine months endedSeptember 30, 2005, a decrease of $0.05 per MMBtu, or 0.8%.  Averagerealized NGL sales prices were $1.06 per gallon for the nine months endedSeptember 30, 2006 compared to $0.95 per gallon for the nine months endedSeptember 30, 2005, an increase of $0.11 per gallon or 11.6%.  The changein our average realized NGL sales prices was primarily a result of higher indexprices due to a tightening of supply and demand fundamentals for energy, whichcaused crude oil prices to rise during the nine months ended September 30, 2006compared to the nine months ended September 30, 2005.

Cash received fromour counterparty on cash flow swap contracts that began on May 1, 2006 fornatural gas derivative transactions that closed during the nine months endedSeptember 30, 2006 totaled $2.4 million. This gain increased average realized natural gas sales prices to $6.30per MMBtu from $6.16 per MMBtu, an increase of $0.14 per MMBtu, or 2.3%.  We had no derivative transactions during thenine months ended September 30, 2005.

Fees earned from afive-month average of 129,644 MMBtu/d of natural gas gathered, in which we donot take title to the gas, related to our Kinta Area gathering assets weacquired on May 1, 2006 were $4.5 million for the nine months ended September30, 2006. The five-month average of 129,644 equates to an average 72,657 forthe nine months ended September 30, 2006. We had no similar fees from natural gas gathering during the nine monthsended September 30, 2005.

Compressionrevenues were $3.6 million for the nine months ended September 30, 2006compared to $3.0 million for the nine months ended September 30, 2005, anincrease of $0.6 million or 20.0%.  Thecompression assets were contributed by Hiland Partners, LLC on February 15,2005, and accordingly, revenues from these assets were only included for sevenand one-half months of the nine months ended September 30, 2005.

***Midstream Purchases.***  Midstreampurchases were $118.0 million for the nine months ended September 30, 2006compared to $77.6 million for the nine months ended September 30, 2005, anincrease of $40.4 million, or 52.1%.  Of the $40.4 million increase, $28.9million, or 71.5% was attributable to purchases as a result of our Bakkengathering system acquisition effective September 1, 2005 and $5.4 million, or13.3% was attributable to purchases as a result of our Kinta Area gatheringassets we acquired on May 1, 2006.  Theincrease in purchases is also attributable to the inclusion of the Worlandgathering system for the entire nine months in 2006 as compared to only sevenand one-half months of the corresponding period in 2005.

***Operations and Maintenance.*** Operations and maintenance expense totaled $11.1 million for the nine monthsended September 30, 2006 compared with $5.1 million for the nine months endedSeptember 30, 2005, an increase of $6.0 million, or 119.2%. Of this increase,$2.8 million, or 46.4% was attributable to operations and maintenance as aresult of our Kinta Area gathering assets we acquired on May 1, 2006 and $2.1million, or 34.6% was attributable to operations and maintenance at our Bakkengathering system we acquired effective September 1, 2005. The increase inoperations and maintenance is also attributable to the inclusion of theWorland gathering system for the entire nine months in 2006 as compared to onlyseven and one-half months of the corresponding period in 2005.

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***Depreciation, Amortization and Accretion.*** Depreciation, amortization and accretion expense totaled $15.8 million for thenine months ended September 30, 2006 compared with $6.9 million for the ninemonths ended September 30, 2005, an increase of $8.9 million, or 128.4%. Of this increase, $4.6 million, or 52.1% was attributable to depreciation andamortization on our Bakken gathering system we acquired effective September 1,2005 and $3.3 million, or 37.5% was attributable to depreciation andamortization on our Kinta Area gathering assets we acquired on May 1, 2006. Theincrease in depreciation, amortization and accretion is also attributable tothe inclusion of the Worland gathering system for the entire nine months in2006 as compared to only seven and one-half months of the corresponding periodin 2005.

***General and Administrative.*** General and administrative expense totaled $3.6 million for the nine monthsended September 30, 2006 compared with $1.5 million for the nine months endedSeptember 30, 2005, an increase of $2.1 million, or 137.4%.  The increaseis primarily attributable to increased salaries and additional staffing of $0.9million as a result of growth and $0.8 million in Sarbanes-Oxley internalcontrol compliance costs and audit and tax preparation fees.

***Other Income (Expense).*** Otherincome (expense) totaled ($3.7) million for the nine months ended September 30,2006 compared with ($1.0) million for the nine months ended September 30, 2005,an increase in expense of $2.7 million.  The increase is primarilyattributable to interest expense associated with borrowings of $61.2 million onour credit facility to partially finance the Kinta Area gathering assets weacquired on May 1, 2006 and the interest expense associated with the partialfinancing of the acquisition of the Bakken gathering system effective September1, 2005.

**LIQUIDITYAND CAPITAL RESOURCES**

***Overview***

Cash generatedfrom operations, borrowings under our credit facility and funds from privateand public equity offerings have historically been our primary sources ofliquidity. We believe that funds from these sources should be sufficient tomeet both our short-term working capital requirements and our long-term capitalexpenditure requirements. Our ability to pay distributions to our unitholders,to fund planned capital expenditures and to make acquisitions depends upon ourfuture operating performance, and more broadly, on the availability of equityand debt financing, which will be affected by prevailing economic conditions inour industry and financial, business and other factors, some of which arebeyond our control.

***Cash Flows from Operating Activities***

Our cash flowsfrom operating activities increased by $29.3 million to $30.2 million for thenine months ended September 30, 2006 from $0.9 million for the nine monthsended September 30, 2005.  Approximately $13.8 million of the increase isattributable to higher net income plus depreciation and amortization during thenine months ended September 30, 2006 as compared to the nine months endedSeptember 30, 2005.  In addition, changesin working capital items exclusive of cash contributed $2.9 million to cashflows from operating activities during the nine months ended September 30, 2006as compared to reducing cash flows from operating activities by $12.6 millionfor the nine months ended September 30, 2005. The use of cash in operating activities in 2005 was primarily a resultof replenishing our accounts receivable after the closing of our initial publicoffering and increased accounts receivable as a result of higher realizedprices for natural gas and NGLs.  Inconnection with our formation, the $9.1 million accounts receivables of CGI wasretained by former owners of CGI. Decreased natural gas and NGL prices at September 30, 2006 as comparedto natural gas and NGL prices at December 31, 2005, offset by the effect of ouracquisition of the Kinta Area gathering assets contributed to decreases inaccounts receivable and accrued midstream revenues during the nine months endedSeptember 30, 2006.  Accounts payable andaccrued midstream purchases during the nine months ended September 30, 2006decreased due to a reduction in natural gas and NGL purchase prices atSeptember 30, 2006 as compared to natural gas and NGL prices at December 31,2005, but was somewhat offset by increased vendor payables relating to internalexpansion and growth projects and additional accounts payable relating to theoperations of the Kinta Area gathering assets acquired on May 1, 2006.

***Cash Flows Used for Investing Activities***

Cash flows used ininvesting activities, which represent investments in property and equipment andpayments made for acquisitions, increased to $144.3 million from $65.2 million,an increase of $79.1 million for the nine months ended September 30, 2006 ascompared to the nine months ended September 30, 2005. The increase is primarilya result of the Kinta Area gathering assets acquisition on May 1, 2006, theongoing progress on our Badlands expansion project and continued growth at ourBakken gathering system.

###### ***Cash Flows from Financing Activities***

Our cash flowsfrom financing activities increased to $117.1 million for the nine months endedSeptember 30, 2006 from $70.9 million for the nine months ended September 30,2005. During the nine months ended September 30, 2006, we borrowed $100.3million under our credit facility to partially fund the Kinta Area gatheringassets acquisition on May 1, 2006 and to fund our internal expansion projectsat Badlands, Kinta and Bakken. During the nine months ended September 30, 2006,we received capital contributions of $35.0 million from our general partner inexchange for the issuance of 761,714 common units and 15,545 general 

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partner equivalent unitsand $1.1 million as a result of issuing common units due to the exercise of47,533 vested unit options. During the nine months ended September 30, 2006 weincurred $0.9 million of debt issuance costs and distributed $18.4 million toour unitholders. We completed our initial public offering of 2,300,000 commonunits on February 15, 2005, receiving net proceeds of $48.1 million. Theproceeds from the public offering were used to (1) pay remaining offering costsof $2.2 million and deferred debt issuance costs of $0.6 million, (2) payoutstanding indebtedness of $22.9 million, (3) redeem $6.3 million of commonunits from an affiliate of Harold Hamm and the Hamm Trusts, and (4) make a $3.9million distribution to the previous owners of Hiland Partners, LLC.  Weretained $12.2 million to replenish working capital.  During the periodfrom January 1, 2005 to February 14, 2005, CGI repaid $1.1 million of itsoutstanding indebtedness.

***Capital Requirements***

Our midstreamenergy business is capital intensive, requiring significant investment tomaintain and upgrade existing operations.  Our capital requirements haveconsisted primarily of, and we anticipate will continue to be:

•              maintenance capital expenditures, whichare capital expenditures made to replace partially or fully depreciated assetsto maintain the existing operating capacity of our assets and to extend theiruseful lives, or other capital expenditures that are incurred in maintainingexisting system volumes and related cash flows; and

•              expansion capital expenditures such asthose to acquire additional assets to grow our business, to expand and upgradegathering systems, processing plants, treating facilities and fractionationfacilities and to construct or acquire similar systems or facilities.

We believe thatcash generated from the operations of our business will be sufficient to meetanticipated maintenance capital expenditures and anticipate that expansioncapital expenditures will be funded through long-term borrowings or other debtfinancings and/or equity offerings.  See “Credit Facility” below forinformation related to our credit agreement.

A summary of ourcontractual cash obligations as of September 30, 2006, which include expansionprojects on our Badlands, Kinta Area and Bakken gathering systems, is presentedbelow:
| ** **                                | ** ** | **Payment Due by Period** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| **Type of Obligation**          | ** ** | **Total  Obligation**                    | ** ** | **Due in  2006** | ** ** | **Due in  2007** | ** ** | **Due in  2008** | ** ** | **Due in  2009** | ** ** | **Thereafter** | ** ** |
| ** **                                | ** ** | **(in thousands)**                  | ** ** |
| Senior secured  revolving credit facility |       | $                                        | 134,064    |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 134,064 |   |
| Contracts on  internal expansion projects |       | 11,554                                   |       | 5,111 |   | 6,443 |   | — |   | — |   | — |   |
| Operating leases  and service agreements  |       | 2,693                                    |       | 281 |   | 1,083 |   | 325 |   | 325 |   | 679 |   |
| Total contractual cash  obligations       |       | $                                        | 148,311    |   | $ | 5,392 |   | $ | 7,526 |   | $ | 325 |   | $ | 325 |   | $ | 134,743 |   |

 

***Badlands Expansion Project***

On November 8,2005, we entered into a new 15-year definitive Gas Purchase Agreement withContinental Resources, Inc. under which we will gather, treat and processadditional natural gas, which is produced as a by-product of ContinentalResources’ secondary oil recovery operations, in the areas specified by thecontract.  In order to fulfill our obligations under the agreement, weintend to expand our Badlands gas gathering system and processing plant locatedin Bowman County, North Dakota.  This expansion project will include theconstruction of a 40,000 Mcf/d nitrogen rejection plant and the expansion ofour existing Badlands field-gathering infrastructure.  The expansionproject, which is targeted for completion in the first quarter of 2007, isexpected to cost approximately $40.0 million, which we intend to fund using ourexisting bank credit facility. As of September 30, 2006, we have invested$27.1 million in the expansion project. Moreover, we expect to spend anadditional $9.4 million in 2007 to expand the system. As of September 30, 2006,we have contractual obligations, including operating lease and serviceagreements related to the expansion project at our Badlands gathering system,totaling $9.3 million.  The cost toexpand the system may exceed our expected costs if our assumptions as toconstruction costs or other factors are incorrect or as a result of otherevents that are beyond our control.

***BakkenExpansion Project***

We have plans toinstall additional gathering and compression infrastructure at our Bakkenfacility in order to reach the system’s expected capacity of approximately25,000 Mcf/d. We expect this expansion will be completed in the fourth quarterof 2006.  We also intend to expand the existing NGL fractionationfacilities in order to fractionate the expected increased NGL volumes from bothour Bakken plant and our Badlands plant.  We expect this expansion will becompleted in the second quarter of 2007. As of September 30, 2006, we have $0.7 million remaining on contractualobligations to purchase two new compressors which we expect to be operationalby the fourth quarter of 2006.

 

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***OtherExpansion Projects***

At our Kinta Areagathering systems, we intend to install four amine-treating facilities toremove excess carbon dioxide levels from the gas and install additionalcompression facilities to expand the current capacity by approximately 11,000Mcf/d. We expect these expansion projects will be completed by first quarter2007.  As of September 30, 2006, we have contractual obligations relatedto the amine-treating facilities of $1.1 million. We also plan to installadditional pipelines and compression facilities at our Eagle Chief gatheringsystem in order to increase our current system capacity from approximately30,000 Mcf/d to approximately 35,500 Mcf/d due to increased volumes on thissystem.  We expect this expansion project will be completed by fourthquarter 2006.

***Financial Derivatives and Commodity Hedges***

We have enteredinto certain financialderivative instruments that are classified as cash flow hedges in accordancewith SFAS No. 133, as amended, and relate to forecasted sales in 2006, 2007 and2008. We entered into these instruments to hedge the forecasted natural gas andNGL sales or purchases against the variability in expected future cash flowsattributable to changes in market prices. The swap instruments are contractualagreements between a counterparty and us to exchange obligations of money asthe underlying natural gas or NGLs are sold or purchased. Under these swapagreements, we either receive or pay a monthly net settlement that isdetermined by the difference between a fixed price and a floating price basedon certain indices for the relevant contract period for the agreed uponvolumes.  The following tableprovides information about these financial derivative instruments for theperiods indicated:

 

| Description and Production Period           | ** ** | **Volume** | ** ** | **Average  Fixed Price** | ** ** | **Fair Value  Asset  (Liability)** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|-----------------------------------------|------------|
|                                                       |       |       |       |                          |       |                                    |       |
| Natural Gas - Sold  Fixed for Floating Price Swaps         |       | (MMBtu)    |       | (per  MMBtu)                  |       |                                    |       |
| October 2006 -  September 2007                             |       | 1,620,000  |       | $                             | 8.26       |                                    | $          | 4,280 |   |
| October 2007 - December  2008                              |       | 2,025,000  |       | $                             | 8.00       |                                    | 2,544      |   |
|                                                       |       |       |       |                          |       | $                                       | 6,824      |   |
|                                                       |       |       |       |                          | ** ** | ** **                              | ** ** |
| Natural Gas - Buy Fixed  for Floating Price Swaps          |       | (MMBtu)    |       | (per  MMBtu)                  |       |                                    |       |
| October 2006 -  September 2007                             |       | 600,000    |       | $                             | 8.87       |                                    | $          | (1,516 | ) |
| October 2007 - March  2008                                 |       | 300,000    |       | $                             | 8.87       |                                    | (398       | ) |
| ** **                                                 |       |       |       |                          |       | $                                       | (1,914     | ) |
| Natural Gas Liquids -  Sold Fixed for Floating Price Swaps |       | (Bbls)     |       | (per  Gallon)                 |       |                                    |       |
| October 2006 -  September 2007                             |       | 152,652    |       | $                             | 1.13       |                                    | $          | (113 | ) |
| October 2007 - March  2008                                 |       | 76,326     |       | $                             | 1.13       |                                    | (154       | ) |
|                                                       |       |       |       |                          |       | $                                       | (267       | ) |
|                                                       |       |       |       |                          |       |                                    |       |

 

In addition to thecontractual obligations noted in the table above, we have executed variousnatural gas fixed price physical forward sales contracts on approximately100,000 MMBtu per month for the remainder of 2006 and all of 2007 and 2008 withfixed prices ranging from $4.47 to $9.52 per MMBtu in 2006, $4.49 to $9.13 perMMBtu in 2007 and $8.43 per MMBtu in 2008. These contracts have been designated as normal sales under SFASNo. 133 and are therefore not marked to market as derivatives.  A summary of our fixed price physical forwardsales contracts is presented in the table below:

| Production period         | ** ** | **(MMBtu)** | ** ** | **Average  Fixed Price  (per MMBtu)** | ** ** |
|--------------------------------|------------|-------------|------------|-------------------------------------------------|------------|
|                           |       |        |       |                                            |       |
| October 2006 -  September 2007 |       | 1,200,000   |       | $                                               | 6.86       |   |
| October 2007 - December 2008   |       | 1,500,000   |       | $                                               | 8.11       |   |

 

***Off-Balance Sheet Arrangements***

We had nooff-balance sheet arrangements as of September 30, 2006.

***Credit Facility***

Concurrently withthe closing of our initial public offering, we entered into a three-year$55.0 million senior secured revolving credit facility.  On September 26, 2005, concurrently withthe closing of the Bakken acquisition, we amended this facility to increase ourborrowing capacity under the facility to $125.0 million. On May 1, 2006,we, through our wholly owned operating subsidiary, Hiland Operating, LLCcompleted our acquisition of Enogex Gas Gathering, L.L.C.’s eastern OklahomaKinta Area gathering assets for $96.4 million in cash. We used $61.2 million ofour bank revolving credit facility to partially fund the acquisition.

On June 8,2006, we entered into a second amendment to our credit facility to, among otherthings, increase our borrowing base 

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to $200 million andrevise certain covenants. The facility currently consists of a$191.0 million senior secured revolving credit facility to be used forfunding acquisitions and other capital expenditures, issuance of letters ofcredit and general corporate purposes (the “revolving acquisition facility”);and a $9.0 million senior secured revolving credit facility to be used forworking capital and to fund distributions (the “revolving working capitalfacility”).

In addition, ourcredit facility provides for an accordion feature, which permits us, if certainconditions are met, to increase the size of the revolving acquisition facilityby up to $150 million and allows for the issuance of letters of credit ofup to $15.0 million in the aggregate. The credit facility will mature inMay 2011. At that time, the agreement will terminate and all outstandingamounts thereunder will be due and payable.

Our obligationsunder the credit facility are secured by substantially all of our assets andguaranteed by us, and all of our subsidiaries, other than our operatingcompany, which is the borrower under the credit facility.

Indebtedness underthe credit facility will bear interest, at our option, at either (i) anAlternate Base Rate plus an applicable margin ranging from 50 to 125 basispoints per annum or (ii) LIBOR plus an applicable margin ranging from 150to 225 basis points per annum based on our ratio of consolidated funded debt toEBITDA. The Alternate Base Rate is a rate per annum equal to the greatest of(a) the Prime Rate in effect on such day, (b) the base CD rate ineffect on such day plus 1.50% and (c) the Federal Funds effective rate ineffect on such day plus 1/2of 1%. A letter of credit fee will be payable for the aggregate amount ofletters of credit issued under the credit facility at a percentage per annumequal to 1.0%. An unused commitment fee ranging from 25 to 50 basis points perannum based on our ratio of consolidated funded debt to EBITDA will be payableon the unused portion of the credit facility. During any step-up period, theapplicable margin with respect to loans under the credit facility will beincreased by 35 basis points per annum and the unused commitment fee will beincreased by 12.5 basis points per annum.

The creditfacility prohibits us from making distributions to unitholders if any defaultor event of default, as defined in the credit facility, has occurred and iscontinuing or would result from the distribution. In addition, the creditfacility contains various covenants that limit, among other things, subject tocertain exceptions and negotiated “baskets,” our ability to incur indebtedness,grant liens, make certain loans, acquisitions and investments, make anymaterial changes to the nature of its business, amend its material agreements,including the Omnibus Agreement or enter into a merger, consolidation or saleof assets.

The creditfacility also contains covenants requiring us to maintain a maximumconsolidated funded debt to EBITDA ratio of 4.0:1.0, provided that in the eventwe make certain permitted acquisitions or capital expenditures, the creditfacility allows this ratio to increase to 4.75:1.0 for the following threefiscal quarters (a “step-up period”) and a minimum interest coverage ratio of3.0:1.0.

The creditfacility defines EBITDA as our consolidated net income, plus income taxexpense, interest expense, depreciation and amortization expense, amortizationof intangibles and organizational costs, non-cash unit based compensationexpense, and adjustments for non-cash gains and losses on specified derivativetransactions and for other extraordinary items.

Upon theoccurrence of an event of default as defined in the credit facility, thelenders may, among other things, be able to accelerate the maturity of thecredit facility and exercise other rights and remedies as set forth in thecredit facility.

The creditfacility limits distributions to our unitholders to available cash, as definedby the agreement, and borrowings to fund such distributions are only permittedunder the revolving working capital facility. The revolving working capitalfacility is subject to an annual “clean-down” period of 15 consecutive days inwhich the amount outstanding under the revolving working capital facility isreduced to zero.

As of September30, 2006, we had $134.1 million outstanding under the credit facility andwere in compliance with its financial covenants.

***Impact of Inflation***

Inflation in theUnited States has been relatively low in recent years and did not have amaterial impact on our results of operations for the periods presented.

**RecentAccounting Pronouncements**

In October 1995the FASB issued SFAS No. 123, “Share-Based Payment,” which was revised inDecember 2004 (“SFAS 123R”). FASB 123R requires that the compensationcost relating to share-based payment transactions be recognized in thefinancial statements and that cost be measured based on the fair value of theequity or liability instruments issued. We adopted SFAS 123R as of January1, 2006 and applied SFAS 123R using the permitted modified prospective methodbeginning as of the same date and our unearned deferred compensation of $289 asof January 1, 2006 has been eliminated against common unit equity. Prior toJanuary 1, 2006 we recorded and unamortized compensation related to restrictedunit awards as unearned compensation in equity. We expect no change to our cashflow presentation from the adoption of SFAS 123R since no tax benefits arerecognized by us as a pass 

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through entity. Ourcompensation expense for these awards is recognized on the acceleratedattribution method. Units to be issued under our unit incentive plan willresult from newly issued units.  Nocompensation expense was recognized in 2005 for our unit options granted during2005. Prior to our adoption of SFAS 123R on January 1, 2006, we appliedAccounting Principles Board Opinion No. 25 and related interpretations inaccounting for our unit-based compensation awards. We had 152,300 optionsoutstanding as of September 30, 2006.

In September 2006,the FASB issued SFAS No. 157 “Fair Value Measurements.”  SFAS No. 157 defines fair value as the pricethat would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date,establishes a framework for measuring fair value in generally acceptedaccounting principles (GAAP) such as fair value hierarchy used to classify thesource of information used in fair value measurements (i.e., market based ornon-market based) and expands disclosure about fair value measurements based ontheir level in the hierarchy.  ThisStatement applies to derivatives and other financial instruments, whichStatement 133, *Accounting for DerivativeInstruments and Hedging Activities*, requires be measured at fairvalue at initial recognition and for all subsequent periods. This Statement iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007 and interim periods within those fiscal years. We will applythe provisions of the Statement prospectively in our first interim period inthe fiscal year beginning on January 1, 2008 and we do not expect a change in ourmethodologies of fair value measurements.

In September 2006,the SEC staff issued Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements.”  SAB 108 wasissued to provide consistency between how registrants quantify financialstatement misstatements. Historically, there have been two widely used methodsfor quantifying the effects of financial statement misstatements.  These methods are referred to as the “roll-over”and “iron curtain” method.  The roll-overmethod quantifies the amount by which the current year income statement ismisstated.  Exclusive reliance on anincome statement approach can result in the accumulation of errors on thebalance sheet that may not have been material to any individual incomestatement, but which may misstate one or more balance sheet accounts. The ironcurtain method quantifies the error as the cumulative amount by which thecurrent year balance sheet is misstated. Exclusive reliance on a balance sheet approach can result indisregarding the effects of errors in the current year income statement thatresults from the correction of an error existing in previously issued financialstatements.  SAB 108 established anapproach that requires quantification of financial statement misstatementsbased on the effects of the misstatement on each of the company’s financialstatements and the related financial statement disclosures.  This approach is commonly referred to as the “dualapproach” because it requires quantification of errors under both the roll-overand iron curtain methods. We will initially apply SAB 108 in connection withthe preparation of our annual financial statements for the year ending December31, 2006 and we do not expect to record an adjustment.

**SignificantAccounting Policies and Estimates**

The selection andapplication of accounting policies is an important process that has developedas our business activities have evolved and as the accounting rules havedeveloped.  Accounting rules generally do not involve a selection amongalternatives, but involve the implementation and interpretation of existingrules, and the use of judgment applied to the specific set of circumstancesexisting in our business.  We make every effort to properly comply withall applicable rules on or before their adoption, and we believe the properimplementation and consistent application of the accounting rules arecritical.  For further details on our accounting policies, you should readNote 1 of the accompanying Notes to Financial Statements.

***Revenue Recognition*.   **Revenuesfor sales of natural gas and NGLs product sales are recognized at the time theproduct is delivered and title is transferred.  Revenues for compressionservices are recognized when the services under the agreement are performed.

***Derivatives.   ***Weutilize derivative financial instruments to reduce commodity price risks. We donot hold or issue derivative financial instruments for trading purposes.Statement of Financial Accounting Standards (or SFAS) No. 133, Accountingfor Derivative Instruments and Hedging Activities, which was amended inSeptember 2000 by SFAS No. 138 and in May 2003 by SFAS No. 149,establishes accounting and reporting standards for derivative instruments andhedging activities. It requires that an entity recognize all derivatives aseither assets or liabilities in the statement of financial condition andmeasure those instruments at fair value. Derivatives that are not designated ashedges are adjusted to fair value through income. If the derivative isdesignated as a hedge, depending upon the nature of the hedge, changes in thefair value of the derivatives are either offset against the fair value ofassets, liabilities or firm commitments through income, or recognized in othercomprehensive income until the hedged item is recognized in income. Theineffective portion of a derivative’s change in fair value is immediatelyrecognized into income. If a derivative no longer qualifies for hedgeaccounting the amounts in accumulated other comprehensive income will beimmediately charged to operations.

**Item3.   Quantitative and Qualitative Disclosures about Market Risk**

Market risk is therisk of loss arising from adverse changes in market rates and prices.  Theprincipal market risk to which we are exposed is commodity price risk fornatural gas and NGLs.  We also incur, to a lesser extent, risks related tointerest rate fluctuations.  We do not engage in commodity energy tradingactivities.

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***Commodity Price Risks. *** Ourprofitability is affected by volatility in prevailing NGL and natural gasprices.  Historically, changes in the prices of most NGL products havegenerally correlated with changes in the price of crude oil.  NGL andnatural gas prices are volatile and are impacted by changes in the supply anddemand for NGLs and natural gas, as well as market uncertainty.  Toillustrate the impact of changes in prices for natural gas and NGLs on ouroperating results, we have provided below, a matrix that reflects, for the ninemonths ended September 30, 2006, the impact on our gross margin of a $0.01 pergallon change (increase or decrease) in NGL prices coupled with a $0.10 perMMBtu change (increase or decrease) in the price of natural gas.  Themagnitude of the impact on total segment margin of changes in natural gas andNGL prices presented may not be representative of the magnitude of the impacton total segment margin for different commodity prices or contractportfolios.  Natural gas prices can also affect our profitabilityindirectly by influencing the level of drilling activity and relatedopportunities for our services.

|                    | ** ** | **Natural Gas Price Change ($/MMBtu)** | ** ** |
|--------------------|------------|------------------------------------------------------------|------------|
|          |       |                                                  |       | $ | 0.10 |   | $ | (0.10 | ) |
| **NGL Price**      |       | $                                                          | 0.01       |   | $ | 81,000 |   | $ | 51,000 |   |
| **Change ($/gal)** |       | $                                                          | (0.01      | ) | $ | (56,000 | ) | $ | (182,000 | ) |

 

Wemanage this commodity price exposure through an integrated strategy thatincludes management of our contract portfolio, optimization of our assets andthe use of derivative contracts. As a result of these derivative swapcontracts, we have hedged a portion of our expected exposure to natural gasprices and NGL prices in 2006, 2007 and 2008. We continually monitor ourhedging and contract portfolio and expect to continue to adjust our hedgeposition as conditions warrant. The following table provides information aboutour derivative instruments for the periods indicated:

| Description and Production Period           | ** ** | **Volume** | ** ** | **Average  Fixed Price** | ** ** | **Fair Value  Asset  (Liability)** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|-----------------------------------------|------------|
|                                                       |       |       |       |                          |       |                                    |       |
| Natural Gas - Sold  Fixed for Floating Price Swaps         |       | (MMBtu)    |       | (per  MMBtu)                  |       |                                    |       |
| October 2006 -  September 2007                             |       | 1,620,000  |       | $                             | 8.26       |                                    | $          | 4,280 |   |
| October 2007 - December  2008                              |       | 2,025,000  |       | $                             | 8.00       |                                    | 2,544      |   |
|                                                       |       |       |       |                          |       | $                                       | 6,824      |   |
|                                                       |       |       |       |                          |       |                                    |       |
| Natural Gas - Buy Fixed  for Floating Price Swaps          |       | (MMBtu)    |       | (per  MMBtu)                  | ** ** | ** **                              | ** ** |
| October 2006 -  September 2007                             |       | 600,000    |       | $                             | 8.87       |                                    | $          | (1,516 | ) |
| October 2007 - March  2008                                 |       | 300,000    |       | $                             | 8.87       |                                    | (398       | ) |
|                                                       | ** ** | ** ** | ** ** | ** **                    |       | $                                       | (1,914     | ) |
|                                                       |       |       |       |                          |       |                                    |       |
| Natural Gas Liquids -  Sold Fixed for Floating Price Swaps |       | (Bbls)     |       | (per  Gallon)                 |       |                                    |       |
| October 2006 -  September 2007                             |       | 152,652    |       | $                             | 1.13       |                                    | $          | (113 | ) |
| October 2007 - March  2008                                 |       | 76,326     |       | $                             | 1.13       |                                    | (154       | ) |
|                                                       |       |       |       |                          |       | $                                       | (267       | ) |
|                                                       |       |       |       |                          |       |                                    |       |

 

Inaddition to the contractual obligations noted in the table above, we haveexecuted various natural gas fixed price physical forward sales contracts onapproximately 100,000 MMBtu per month for the remainder of 2006 and all of 2007and 2008 with fixed prices ranging from $4.47 to $9.52 per MMBtu in 2006, $4.49to $9.13 per MMBtu in 2007 and $8.43 per MMBtu in 2008.  These contracts have been designated asnormal sales under SFAS No. 133 and are therefore not marked to market asderivatives.  A summary of our fixedprice physical forward sales contracts is presented in the table below:

| Production Period         | ** ** | **(MMBtu)** | ** ** | **Average  Fixed Price  (per MMBtu)** | ** ** |
|--------------------------------|------------|-------------|------------|-------------------------------------------------|------------|
| ** **                     | ** ** | ** **  | ** ** | ** **                                      | ** ** |
| October 2006 -  September 2007 |       | 1,200,000   |       | $                                               | 6.86       |   |
| October 2007 - December  2008  |       | 1,500,000   |       | $                                               | 8.11       |   |
|                           |       |        |       |                                            |       |

 

***Interest Rate Risk*.**   We areexposed to changes in interest rates as a result of our credit facility, whichhas floating interest rates.  On May 1, 2006 we borrowed $61.2 million topartially fund our Kinta Area assets acquisition from Enogex Gas Gathering,L.L.C. During the nine months ended September 30, 2006, we borrowed another$20.4 million to fund our various expansion projects.  As of September 30, 2006, we hadapproximately $134.1 million of indebtedness outstanding under our creditfacility.  The impact of a 100 basis point increase in interest rates onthe amount of current debt would result in an increase in interest expense, anda corresponding decrease in net income, of approximately $1.3 million annually.

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***Credit Risk*.**  Counterparties pursuant to the terms of their contractual obligations expose usto potential losses as a result of nonperformance.  Our four largestcustomers for the nine months ended September 30, 2006, accounted forapproximately 17%, 16%, 14% and 12%, respectively, of our revenues. Consequently, changes within one or more of these companies operations have thepotential to impact, both positively and negatively, our credit exposure. Ourcounterparty for all of our derivative instruments as of September 30, 2006 isBP Energy Company.

**Item4.   Controls and Procedures**

**Evaluationof Disclosure Controls and Procedures**

(a)  Evaluation ofdisclosure controls and procedures.

Our principal executiveofficer and principal financial officer have evaluated, as required byRule 13a-15(b) under the Securities Exchange Act of 1934 (the “ExchangeAct”), our disclosure controls and procedures (as defined in Exchange Act Rule13a-15(e)) as of the end of the period covered by this quarterly report onForm 10-Q.   Based on that evaluation, the principal executiveofficer and principal financial officer concluded that the design and operationof our disclosure controls and procedures are effective in ensuring thatinformation we are required to disclose in the reports that we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’s rulesand forms.

(b) Changes ininternal control over financial reporting.

There have been nochanges in our internal control over financial reporting (as defined inRule 13a-15(f) under the Exchange Act) that occurred during our lastfiscal quarter that have materially affected or are reasonably likely tomaterially affect our internal control over financial reporting.

**PART II.OTHER INFORMATION**

**Item1. Legal Proceedings**

We are a party to variouslegal and regulatory proceedings, none of which we believe will have a materialadverse impact on our financial condition, results of operations or cash flows.

**Item1A. Risk Factors**

In addition to the otherinformation set forth in this report, you should carefully consider the factorsdiscussed in Part 1, Item 1A. “Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2005, which could materially affect ourbusiness, financial condition or future results. The risks described in ourAnnual Report on Form 10-K are not the only risks facing our Company.Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.

**Item2. Unregistered Sales of Equity Securities and Use of Proceeds**

On May 1, 2006, weentered into a Unit Purchase Agreement with our general partner, pursuant towhich our general partner purchased 761,714 common units and 15,545 generalpartner units for an aggregate purchase price of $35.0 million.  We issued the units to our general partner onMay 10, 2006 and used the proceeds to fund a portion of our acquisition of theKina Area gathering assets from Enogex Gas Gathering, L.L.C.  We relied on Section 4(2) of the SecuritiesAct of 1933, as amended, as an exemption from registration of the units issued.

Please see our CurrentReport on Form 8-K filed May 3, 2006, which is incorporated herein byreference.

**Item3. Defaults Upon Senior Securities**

None.

**Item4.  Submission of Matters to a Vote of Security Holders**

None.

**Item5. Other Information**

None.

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**Item6. Exhibits**
| Exhibit  Number | ** ** | ** ** | ** ** | **Description**                                                                                    |
|-----------------|------------|------------|------------|----------------------------------------------------------------------------------------------------|
| 31.1            |       | —     |       | Certification of Chief Executive Officer under  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2            |       | —     |       | Certification of Chief Financial Officer under  Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1            |       | —     |       | Certification of Chief Executive Officer under  Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2            |       | —     |       | Certification of Chief Financial Officer under  Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized in the city of Enid, Oklahoma, on the13th day of November, 2006.
|            | **HILAND PARTNERS, LP**                              |
|------------|------------------------------------------------------|
|       |                                                 |   |
| ** ** | **By: Hiland Partners GP, LLC, its general partner** |
| ** ** | ** **                                           | ** ** |
|       | By:                                                  | /s/ Randy Moeder |
|       |                                                 | Randy Moeder |
|       |                                                 | Chief Executive Officer, President and Director |
|       |                                                 |   |
|       | By:                                                  | /s/ Ken Maples |
|       |                                                 | Ken Maples |
|       |                                                 | Chief Financial Officer, Vice President—Finance, |
|       |                                                 | Secretary and Director |

 

 

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**Exhibit Index**
| 31.1   | — | Certification of Chief Executive Officer under  Section 302 of the Sarbanes-Oxley Act of 2002 |
|--------|--------|----------------------------------------------------------------------------------------------------|
|   |   |                                                                                               |
| 31.2   | — | Certification of Chief Financial Officer under  Section 302 of the Sarbanes-Oxley Act of 2002 |
|   |   |                                                                                               |
| 32.1   | — | Certification of Chief Executive Officer under  Section 906 of the Sarbanes-Oxley Act of 2002 |
|   |   |                                                                                               |
| 32.2   | — | Certification of Chief Financial Officer under  Section 906 of the Sarbanes-Oxley Act of 2002 |

 

 

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