**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

** **

**FORM10-Q**

** **

ý** QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF1934**

** **

**FOR THEQUARTERLY PERIOD ENDED March 31, 2006**

** **

**OR**

 

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

**THE SECURITIES EXCHANGE ACT OF1934**

** **

**FOR THETRANSITION 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’s telephonenumber including area code**(580) 242-6040**

** **

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days Yes ýNo o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

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

 

Indicate by a check mark whether the registrant is a shell company (asdefined in rule 12b-2 of the Exchange Act). Yes oNo ý

 

The number of the registrant’s outstanding equity units at May 4, 2006was 4,397,633 common units, 4,080,000 subordinated units and a 2% generalpartnership interest.

 

 

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**HILANDPARTNERS, LP**

**INDEX**

** **
| **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 Owners’ Equity                                                       |       |
| Condensed  Notes to Consolidated Financial Statements                                                |       |
| Item  1A. Risk Factors                                                                               |       |
| 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 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                                                               |       |

 

2

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**HILANDPARTNERS, LP**

**Consolidated Balance Sheets**

 
| ** **                                                                                                                        | ** ** | **March 31,**                           | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|------------------|------------|
| ** **                                                                                                                        | ** ** | **2006**                                | ** ** | **2005**         | ** ** |
| ** **                                                                                                                        | ** ** | **(unaudited)**                         | ** ** | ** **       | ** ** |
| ** **                                                                                                                        | ** ** | **(in thousands, except unit amounts)** | ** ** |
| **ASSETS**                                                                                                                        | ** ** | ** **                              | ** ** | ** **       | ** ** |
| **Current assets:**                                                                                                               | ** ** | ** **                              | ** ** | ** **       | ** ** |
| Cash and cash equivalents                                                                                                         |       | $                                       | 7,243      |             | $          | 6,187 |   |
| Accounts receivable:                                                                                                              |       |                                    |       |             |       |
| Trade                                                                                                                             |       | 15,768                                  |       | 21,893           |       |
| Affiliates                                                                                                                        |       | 1,170                                   |       | 1,523            |       |
|                                                                                                                              |       | 16,938                                  |       | 23,416           |       |
| Fair value of derivative assets                                                                                                   |       | 2,498                                   |       | 868              |       |
| Other current assets                                                                                                              |       | 587                                     |       | 395              |       |
| Total current assets                                                                                                              |       | 27,266                                  |       | 30,866           |       |
|                                                                                                                              |       |                                    |       |             |       |
| Property and equipment, net                                                                                                       |       | 128,868                                 |       | 120,715          |       |
| Intangibles, net                                                                                                                  |       | 40,076                                  |       | 41,179           |       |
| Fair value of derivative assets                                                                                                   |       | 767                                     |       | 181              |       |
| Other assets, net                                                                                                                 |       | 916                                     |       | 1,028            |       |
|                                                                                                                              |       |                                    |       |             |       |
| **Total assets**                                                                                                                  |       | $                                       | 197,893    |             | $          | 193,969 |   |
|                                                                                                                              |       |                                    |       |             |       |
| **LIABILITIES AND OWNERS’ EQUITY**                                                                                           | ** ** | ** **                              | ** ** | ** **       | ** ** |
| **Current liabilities:**                                                                                                          | ** ** | ** **                              | ** ** | ** **       | ** ** |
| Accounts payable                                                                                                                  |       | $                                       | 9,798      |             | $          | 13,324 |   |
| Accounts payable-affiliates                                                                                                       |       | 4,628                                   |       | 6,122            |       |
| Fair value of derivative liabilities                                                                                              |       | 807                                     |       | —           |       |
| Accrued liabilities                                                                                                               |       | 994                                     |       | 1,126            |       |
| Total current liabilities                                                                                                         |       | 16,227                                  |       | 20,572           |       |
|                                                                                                                              |       |                                    |       |             |       |
| Commitments and contingencies (Note 6)                                                                                            |       |                                    |       |             |       |
| Long-term debt, net of current maturities                                                                                         |       | 41,784                                  |       | 33,784           |       |
| Fair value of derivative liabilities                                                                                              |       | 1,143                                   |       | —           |       |
| Asset retirement obligation                                                                                                       |       | 1,034                                   |       | 1,024            |       |
|                                                                                                                              |       |                                    |       |             |       |
| **Owners’ equity**                                                                                                           | ** ** | ** **                              | ** ** | ** **       | ** ** |
| Limited partners’ interest:                                                                                                  |       |                                    |       |             |       |
| Common  unitholders (4,397,633 and 4,358,000 units issued and outstanding at March  31, 2006 and December 31, 2005, respectively) |       | 109,650                                 |       | 110,027          |       |
| Subordinated  unitholders (4,080,000 units issued and outstanding at March 31, 2006 and  December 31, 2005)                       |       | 24,103                                  |       | 25,126           |       |
| General partner interest                                                                                                          |       | 2,719                                   |       | 2,676            |       |
| Unearned compensation                                                                                                             |       | —                                  |       | (289             | )          |
| Accumulated other comprehensive income                                                                                            |       | 1,233                                   |       | 1,049            |       |
| **Total owners’ equity**                                                                                                     |       | 137,705                                 |       | 138,589          |       |
|                                                                                                                              |       |                                    |       |             |       |
| **Total liabilities and owners’ equity**                                                                                     |       | $                                       | 197,893    |             | $          | 193,969 |   |

 

The accompanying notesare an integral part of these financial statements.

 

3

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**HILANDPARTNERS, LP**

**Consolidated Statements of Operations**

**For theThree Months Ended (Unaudited)**

 
| ** **                                                                  | ** ** | **March 31,**                               | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------|------------|
| ** **                                                                  | ** ** | **2006**                                    | ** ** | **2005**      | ** ** |
| ** **                                                                  | ** ** | **(In thousands, except per unit amounts)** | ** ** |
| **Revenues:**                                                               | ** ** | ** **                                  | ** ** | ** **    | ** ** |
| Midstream operations                                                        |       |                                        |       |          |       |
| Third parties                                                               |       | $                                           | 50,886     |          | $          | 24,191 |   |
| Affiliates                                                                  |       | 1,318                                       |       | 984           |       |
| Compression services, affiliate                                             |       | 1,205                                       |       | 603           |       |
| Total revenues                                                              |       | 53,409                                      |       | 25,778        |       |
|                                                                        |       |                                        |       |          |       |
| **Operating costs and expenses:**                                           | ** ** | ** **                                  | ** ** | ** **    | ** ** |
| Midstream purchases (exclusive of items shown  separately below)            |       | 27,155                                      |       | 13,860        |       |
| Midstream purchases -affiliate (exclusive of items  shown separately below) |       | 14,380                                      |       | 6,343         |       |
| Operations and maintenance                                                  |       | 2,574                                       |       | 1,577         |       |
| Depreciation, amortization and accretion                                    |       | 4,137                                       |       | 1,677         |       |
| General and administrative expenses                                         |       | 1,030                                       |       | 353           |       |
| Total operating costs and expenses                                          |       | 49,276                                      |       | 23,810        |       |
| Operating income                                                            |       | 4,133                                       |       | 1,968         |       |
|                                                                        |       |                                        |       |          |       |
| **Other income (expense):**                                                 | ** ** | ** **                                  | ** ** | ** **    | ** ** |
| Interest and other income                                                   |       | 75                                          |       | 7             |       |
| Amortization of deferred loan costs                                         |       | (123                                        | )          | (205          | )          |
| Interest expense                                                            |       | (535                                        | )          | (134          | )          |
| Other income (expense), net                                                 |       | (583                                        | )          | (332          | )          |
|                                                                        |       |                                        |       |          |       |
| **Net income**                                                              |       | $                                           | 3,550      |          | $          | 1,636 |   |
|                                                                        |       |                                        |       |          |       |
| Less income attributable to predecessor                                     |       | —                                      |       | 493           |       |
| Less general partner interest in net income                                 |       | 386                                         |       | 23            |       |
| **Limited partners’ interest in net income**                           |       | $                                           | 3,164      |          | $          | 1,120 |   |
|                                                                        |       |                                        |       |          |       |
| **Net income per limited partners’ unit – basic**                 |       | $                                           | 0.37       |          | $          | 0.16 |   |
|                                                                        |       |                                        |       |          |       |
| **Net income per limited partners’ unit – diluted**               |       | $                                           | 0.37       |          | $          | 0.16 |   |
|                                                                        |       |                                        |       |          |       |
| **Weighted average limited partners’ units  outstanding -basic**       |       | 8,454                                       |       | 6,800         |       |
|                                                                        |       |                                        |       |          |       |
| **Weighted average limited partners’ units  outstanding -diluted**     |       | 8,502                                       |       | 6,840         |       |

 

The accompanying notesare an integral part of these financial statements.

 

4

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** **

**Consolidated Statements of Cash Flows**

**For theThree Months Ended (Unaudited)**

 
| ** **                                                                                        | ** ** | **March 31,**      | ** ** | **March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                                                                        | ** ** | **2006**           | ** ** | **2005**      | ** ** |
| ** **                                                                                        | ** ** | **(In thousands)** | ** ** |
| **Cash flows from operating activities:**                                                         | ** ** | ** **         | ** ** | ** **    | ** ** |
| Net income                                                                                        |       | $                  | 3,550      |          | $          | 1,636 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                |       |               |       |          |       |
| Depreciation and amortization                                                                     |       | 4,127              |       | 1,669         |       |
| Change in asset retirement obligation                                                             |       | 10                 |       | 8             |       |
| Amortization of deferred loan cost                                                                |       | 123                |       | 205           |       |
| Realized (gain) loss on derivative transactions                                                   |       | (82                | )          | —        |       |
| Unit based compensation                                                                           |       | 107                |       | —        |       |
| (Increase) decrease in current assets, net of  acquisition effects of Hiland Partners, LLC:       |       |               |       |          |       |
| Accounts receivable                                                                               |       | 6,125              |       | (9,849        | )          |
| Accounts receivable - affiliates                                                                  |       | 353                |       | (151          | )          |
| Other current assets                                                                              |       | (192               | )          | (147          | )          |
| Increase  (decrease) in current liabilities, net of acquisition effects of Hiland  Partners, LLC: |       |               |       |          |       |
| Accounts payable                                                                                  |       | (3,526             | )          | (221          | )          |
| Accounts payable-affiliates                                                                       |       | (1,494             | )          | (300          | )          |
| Accrued liabilities                                                                               |       | (131               | )          | 311           |       |
| **Net cash provided by (used in) operating  activities**                                          |       | 8,970              |       | (6,839        | )          |
|                                                                                              |       |               |       |          |       |
| **Cash flows from investing activities:**                                                         | ** ** | ** **         | ** ** | ** **    | ** ** |
| Additions to property and equipment                                                               |       | (11,178            | )          | (281          | )          |
| **Net cash used in investing activities**                                                         |       | (11,178            | )          | (281          | )          |
|                                                                                              |       |               |       |          |       |
| **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                                                                |       | 8,000              |       | —        |       |
| Payments on long-term borrowings                                                                  |       | —             |       | (23,951       | )          |
| Debt issuance costs                                                                               |       | (11                | )          | (825          | )          |
| Proceeds from unit option exercise                                                                |       | 910                |       | —        |       |
| Cash distribution to unitholders                                                                  |       | (5,635             | )          | —        |       |
| **Net cash provided by financing activities**                                                     |       | 3,264              |       | 10,105        |       |
|                                                                                              |       |               |       |          |       |
| Increase for the period                                                                           |       | 1,056              |       | 2,985         |       |
| Beginning of period                                                                               |       | 6,187              |       | 217           |       |
| **End of period**                                                                                 |       | $                  | 7,243      |          | $          | 3,202 |   |
|                                                                                              |       |               |       |          |       |
| Supplementary information                                                                         |       |               |       |          |       |
| Cash paid for interest, net of amounts capitalized                                                |       | $                  | 505        |          | $          | 153 |   |

 

The accompanying notesare an integral part of these financial statements.

 

5

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**HILANDPARTNERS, LP**

**Consolidated Statement of Changes in Owners’ Equity andComprehensive Income**

**For theThree Months Ended March 31, 2006 (Unaudited)**

 
| ** **                                                                | ** ** | ** **          | ** ** | ** **       | ** ** | ** **   | ** ** | ** **       | ** ** | **Accumulated**   | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|--------------|------------|------------------|------------|-------------------|------------|------------|------------|-------------------|------------|
| ** **                                                                | ** ** | ** **          | ** ** | ** **       | ** ** | **General**  | ** ** | ** **       | ** ** | **Other**         | ** ** | ** ** | ** ** | **Total**         | ** ** |
| ** **                                                                | ** ** | **Common**          | ** ** | **Subordinated** | ** ** | **Partner**  | ** ** | **Unearned**     | ** ** | **Comprehensive** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                | ** ** | **Units**           | ** ** | **Units**        | ** ** | **Interest** | ** ** | **Compensation** | ** ** | **Income**        | ** ** | **Total**  | ** ** | **Income**        | ** ** |
| ** **                                                                | ** ** | **(in  thousands)** | ** ** |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| 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              |       | —            |       | —     |       |              |       |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Proceeds from 39,633 common unit  options exercise                   |       | 892                 |       | —           |       | 18           |       | —           |       | —            |       | 910        |       |              |       |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Periodic cash distributions                                               |       | (2,724              | )          | (2,550           | )          | (361         | )          | —           |       | —            |       | (5,635     | )          |              |       |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Unit based compensation                                                   |       | 107                 |       | —           |       | —       |       | —           |       | —            |       | 107        |       |              |       |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Change in fair value of derivatives                                       |       | —              |       | —           |       | —       |       | —           |       | 184               |       | 184        |       | $                 | 184        |   |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Net income                                                                |       | 1,637               |       | 1,527            |       | 386          |       | —           |       | —            |       | 3,550      |       | 3,550             |       |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Comprehensive income                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       | $                 | 3,734      |   |
|                                                                      |       |                |       |             |       |         |       |             |       |              |       |       |       |              |       |
| Balance, March 31, 2006                                                   |       | $                   | 109,650    |             | $          | 24,103       |       | $                | 2,719      |              | $          | —     |       | $                 | 1,233      |   | $ | 137,705 |   |   |   |

 

6

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**HILANDPARTNERS, LP**

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

THREE MONTHS ENDED MARCH31, 2006 AND 2005

(in thousands, exceptunit information or unless otherwise noted)

 

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

** **

Hiland Partners, LP, aDelaware limited partnership (“we,” “us,” “our,” “HPLP” or “the Partnership”),was formed in October 2004 to acquire and operate certain midstream natural gasplants, gathering systems and compression and water injection assets located inthe states of Oklahoma, North Dakota, Wyoming, Texas and Mississippi that werepreviously owned by Continental Gas, Inc. (“Predecessor” or “CGI”) and HilandPartners, LLC. We commenced operations on February 15, 2005, andconcurrently with the completion of our initial public offering, CGIcontributed a substantial portion of its net assets to us.

 

CGI constitutes ourpredecessor. The transfer of ownership of net assets from CGI to us representeda reorganization of entities under common control and was recorded athistorical cost. Accordingly, the financial statements include the historicaloperations of CGI prior to the transfer to us. CGI was formed in 1990 as awholly owned subsidiary of Continental Resources, Inc. (“CRI”).

 

CGI operated in one 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 gathering system andour Bakken gathering system. Hiland Partners, LLC historically owned ourWorland gathering system and our compression services assets, which we acquiredon February 15, 2005, and our Bakken gathering system. Since our initialpublic offering, we have operated in midstream and compression servicessegments. On September 26, 2005, we acquired Hiland Partners, LLC,which at such time owned the Bakken gathering system, for $92.7 million,$35.0 million of which was used to retire outstanding Hiland Partners, LLCindebtedness.

 

The financial statements forthe three months ended March 31, 2006 and 2005 included herein have been prepared without audit, pursuant to the rulesand regulations 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 months ended March 31,2006 are not necessarily indicative of the results of operations that will berealized for the year ending December 31, 2006. 

 

***Principles of Consolidation***

 

The consolidated financial statements include ouraccounts and those of our subsidiaries. All significant intercompanytransactions and balances have been eliminated. The consolidated financialstatements include the net assets and operations of assets owned by CGI (ourpredecessor) from January 1, 2005, certain assets of Hiland Partners, LLC thatwere contributed to us concurrently with the completion of our initial publicoffering on February 15, 2005 and the remaining net assets and operations ofHiland Partners, LLC acquired effective September 1, 2005.

 

***Use of Estimates***

*** ***

The preparation of financialstatements in accordance with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the amounts reported in the financial statements and accompanyingnotes. Actual results could differ from those estimates.

 

***Fair Value of Financial Instruments***

*** ***

Our financial instruments,which require fair value disclosure, consist primarily of cash and cashequivalents, accounts receivable, financial derivatives, accounts payable andbank debt. The carrying value of cash and cash equivalents, accounts receivableand accounts payable are considered to be representative of their respectivefair values, due to the short maturity of these instruments. Derivativeinstruments are reported in the accompanying consolidated financial statementsat fair value in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 133, “Accounting for Derivative Instruments and Hedging Activities,”as amended. Fair value of our derivative instruments is determined basedon management estimates through utilization of market data including forecastedforward natural gas and natural gas liquids prices as a function of forwardNYMEX natural gas and light crude prices. The fair value of long-term debt approximates its carrying value due tothe variable interest rate feature of such debt.

 

***Comprehensive Income (Loss)***

*** ***

Comprehensive income includes net income and othercomprehensive income, which includes, but is not limited to, unrealized gainsand losses on marketable securities, foreign currency translation adjustments,minimum pension liability adjustments and

 

7

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unrealized gains and losses on derivative financial instruments. Therewas no other comprehensive income or loss for the three months ended March 31,2005.

 

Pursuant to SFAS No. 133, we record deferredunrealized hedge gains and losses on our derivative financial instruments thatqualify as cash flow hedges as other comprehensive income.

 

***Net Income per Limited Partners’ Unit***

*** ***

Net income per limitedpartners’ unit is computed based on the weighted-average number of common andsubordinated 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 partners’ unit iscomputed by dividing net income applicable to limited partners, after deductingthe general partner’s 2% interest and incentive distributions, and, for thethree month period ended March 31, 2005, after deducting net incomeattributable to the Predecessor (before February 15, 2005), by both thebasic and diluted weighted-average number of limited partnership units outstanding.

 

***Share-Based Compensation***

*** ***

Our general partner adopted the Hiland Partners, LPLong-Term Incentive Plan for employees and directors of our general partner andemployees of its affiliates, who perform services for us and our generalpartner or its affiliates.  The long-term incentive plan currently permitsan aggregate of 680,000 common units to be issued with respect to unit options,restricted units, and phantom units granted under the plan.  No more than225,000 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 general partner’s board of directors orcompensation committee may, in their discretion, terminate, suspend ordiscontinue the long-term incentive plan at any time with respect to any unitsfor which a grant has not yet been made.  Our general partner’s board ofdirectors or its compensation committee also has the right to alter or amendthe long-term incentive plan or any part of the plan from time to time,including increasing the number of units that may be granted, subject tounitholder approval if required by the exchange upon which the common units arelisted at that time.  No change in any outstanding grant may be made,however, that would materially impair the rights of the participant without theconsent of the participant. Under the unit option grant agreement, grantedoptions of common units will vest and become exercisable in one-thirdincrements on the anniversary of the grant date over three years. Vestedoptions are exercisable within the option’s contractual life of ten years afterthe grant date.

 

In October 1995 the FASB issued SFAS No. 123, “Share-BasedPayment,” which was revised in December 2004 (collectively, “SFAS 123R”) FASB123R requires 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, 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 unit incentive plan will be from newly issuedunits. Accordingly, no compensation expense was recognized in 2005 for our unitoptions granted during 2005. Prior to our adoption of SFAS 123R on January 1,2006, we applied Accounting Principles Board Opinion No. 25 and relatedinterpretations in accounting for our unit-based compensation awards. Thefollowing pro forma data was calculated as if compensation cost for ourunit-based compensation awards during the three month period ended March 31,2005 was determined based upon the fair value at the grant date consistent withthe methodology prescribed under SFAS No. 123. 

 

8

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| ** **                                                   | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                   | ** ** | **March 31, 2005**     | ** ** |
| Net income as reported                                       |       | $                      | 1,636      |   |
| Unit based compensation adjustment                           |       | (136                   | )          |
| Pro forma net income                                         |       | 1,500                  |       |
| Less income attributable to predecessor                      |       | 493                    |       |
| Less general partner interest                                |       | 20                     |       |
| Limited partner’s interest in pro forma net income      |       | $                      | 987        |   |
| Net income per limited partner unit as reported,  basic      |       | $                      | 0.16       |   |
| Net income per limited partner unit as reported, diluted     |       | $                      | 0.16       |   |
| Proforma net income per limited partner unit, basic          |       | $                      | 0.15       |   |
| Proforma net income per limited partner unit,  diluted       |       | $                      | 0.14       |   |
| Weighted average limited partner units outstanding,  basic   |       | 6,800,000              |       |
| Weighted average limited partner units outstanding,  diluted |       | 6,840,000              |       |
|                                                              |            |                        |            |  |  |  |  |

 

The fair value of each optiongranted was estimated on the date of grant using the American Binomial optionpricing model that used the assumptions noted below. Expected andweighted-average volatility is based on our peer group volatility averages asdetermined on the option grant dates. Expected lives of 6.0 years arecalculated by the simplified method as prescribed under SEC Staff AccountingBulletin 107 and represents the period of time that unit options granted are expectedto be outstanding. The risk-free interest rate for periods within thecontractual life of the option is based on the ten-year U.S. Treasury yield ineffect at the time of grant. The exercise price of the options granted equaledthe market price of the units on the grant date. 

 

| ** **                  | ** ** | **Three Months**   | ** ** | **Year Ended**   | ** ** |
|-----------------------------|------------|--------------------|------------|------------------|------------|
| ** **                  | ** ** | **Ended**          | ** ** | **December 31,** | ** ** |
| ** **                  | ** ** | **March 31, 2006** | ** ** | **2005**         | ** ** |
|                        |       |               |       |             |       |
| Expected volatility         |       | 16.1 - 20.2%       |       | 20.2 - 31.0%     |       |
|                        |       |               |       |             |       |
| Weighted-average volatility |       | 18.0%              |       | 29.6%            |       |
|                        |       |               |       |             |       |
| Expected dividend yield     |       | 5.2%               |       | 6.8%             |       |
|                        |       |               |       |             |       |
| Risk-free interest rate     |       | 4.5%               |       | 4.5%             |       |

 

The following tablesummarizes information about outstanding options for the three months endedMarch 31, 2006 and for the year ended December 31, 2005:

 
| ** **                     | ** ** | ** ** | ** ** | ** **    | ** ** | **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                      |       | (39,633    | )          | $             | 22.50      |            |       |          | $          | 653 |   |
|                           |       |       |       |          |       |            |       |          |       |
| Forfeited or expired           |       | —     |       |          |       |            |       |          |       |
|                           |       |       |       |          |       |            |       |          |       |
| Outstanding at March 31, 2006  |       | 155,867    |       | $             | 27.94      |            | 9.1        |          | $          | 2,496 |   |
|                           |       |       |       |          |       |            |       |          |       |
| Exercisable at March 31, 2006  |       | 8,034      |       | $             | 22.50      |            | 8.8        |          | $          | 172 |   |

 

The grant-date fair value ofthe 47,667 options vested during the three months ended March 31, 2006 was$5.11. The weighted-average grant-date fair value of options granted during thethree months ended March 31, 2006 was $4.37. As of March 31, 2006, there was$502 of total unrecognized compensation cost related to unvested unit basedcompensation arrangements granted under our Plan. That cost is expected to berecognized over a weighted-average period of 1.6 years.

 

On April 14, 2006, 13,333 ofthe unit options issued on February 14, 2005, were forfeited. We assumed noforfeitures in our fair value calculations as we believe this forfeiture is anisolated incident and is not indicative of the future. 

 

9

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During the year ended December 31, 2005 we issued8,000 restricted common units to non-employee board members of our generalpartner. A restricted unit is a common unit that is subject toforfeiture.  Upon vesting, the grantee receives a common unit that is notsubject to forfeiture.  The restricted units vest over a four year periodfrom the date of issuance. The weighted average fair value at grant date was$39.69 per unit. Periodic distributions on the restricted units are held intrust by our general partner until the units vest. None of the restricted unitshad vested as of March 31, 2006.

 

As a result of adopting SFAS 123R, we recognizedadditional compensation cost for unit-based payments of $87 and unit awardcompensation expense of $20 for the total unit based compensation expense of$107. Basic and diluted earnings per unit were reduced by $0.01 each to $0.36as a result of the additional $87 compensation recognized under SFAS 123R.

 

***Accounting for Asset Retirement Obligations***

* *

On January 1, 2003, weadopted SFAS No. 143, “Accounting for Asset Retirement Obligations,” thatrequires entities to record the fair value of a liability for an assetretirement obligation in the period in which it is incurred and a correspondingincrease in the carrying amount of the related long-lived asset. Subsequently,the asset retirement cost is allocated to expense using a systematic andrational method and the liability is accreted to measure the change inliability due to the passage of time. The primary impact of this standardrelates to dismantling and site restoration of certain of our plants andpipelines. 

 

The following table summarizes our activity related toasset retirement obligations for the indicated period:

 

| Asset Retirement  Obligation, January 1, 2006 |   | $  | 1,024  |   |
|----------------------------------------------------|--------|----|--------|--------|
| Plus: Accretion expense                            |   | 10 |   |
| Asset Retirement Obligation, March 31, 2006        |   | $  | 1,034  |   |
|                                                    |        |    |        |        |  |

 

***Recent Accounting Pronouncements***

*** ***

*SFASNo. 123, “Share-Based Payment”*

* *

In October 1995, the FASB issued SFAS No. 123,“Share-Based Payments,” 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. 

 

**Note 2:  Acquisitions**

** **

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.

 

To facilitate the closing ofthe acquisition, we amended our senior secured revolving credit facility toincrease our borrowing capacity under the facility from $55.0 million to$125.0 million, consisting of a $117.5 million acquisition facilityand a $7.5 million working capital facility. The credit facility’smaturity date remained the same, February 15, 2008. The current interestrate ranges from LIBOR plus 150 to 275 basis points depending on leveragecoverage. We used a portion of this increased capacity to fund the acquisition.

 

To the extent of ournon-controlling ownership, the acquisition was accounted for using the purchasemethod of accounting under SFAS No. 141, “Business Combinations.” As ofthe date of our acquisition, Hiland Partners, LLC was an entity partiallyowned by a controlling member of our general partner. Accordingly, 49% of theBakken gathering system assets, for which estimated fair value was in excess ofhistorical basis, have been recorded at historical cost and 51% of the Bakkengathering system assets have been recorded at fair value. A cash distributionof $27.8 million made to the controlling member as reported in thestatement of owners’ equity reflects the difference in the purchase price paidto the controlling member of our general partner and his cost basis in the netassets of Hiland Partners, LLC. The fair value of the assets acquired hasalso been reduced by imputed interest expense from

 

10

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September 1, 2005, the effective date ofthe acquisition, through the closing date, September 26, 2005. Thefollowing table presents the resulting allocation to the net assets acquiredand liabilities assumed at the effective 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 |   |

 

Inconnection with our formation and our initial public offering onFebruary 15, 2005, assets and liabilities of Hiland Partners, LLCexcluding the Bakken assets were contributed to us on that date. Inconsideration for the contribution, the non-managing members of Hiland Partners,LLC received 247,868 of our common units and 1,404,586 of our subordinatedunits. Immediately following the closing of the offering, 104,009 of the commonunits were redeemed for approximately $2.2 million The managing member ofHiland Partners, LLC also received 5,059 of our common units and 28,665 of oursubordinated units, none of which were redeemed. The acquisition of the assetsof Hiland Partners, LLC was accounted for as a purchase and, as a result, theseassets were recorded at their fair value at the time of purchase.

 

The following table presentsthe fair value of the assets and liabilities acquired from Hiland Partners, LLCon 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 |   |

 

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

 

11

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| ** **                                                   | ** ** | **Three months**    | ** ** |
|--------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **Ended March 31,** | ** ** |
| ** **                                                   | ** ** | **2005**            | ** ** |
| Revenues as reported                                         |       | $                   | 25,778     |   |
| Revenues from acquired interests                             |       | 5,343               |       |
| Pro forma revenues                                           |       | $                   | 31,121     |   |
|                                                         |       |                |       |
| Net income as reported                                       |       | $                   | 1,636      |   |
| Additional loss from acquired interests                      |       | (1,308              | )          |
| Pro forma net income                                         |       | $                   | 328        |   |
| Less general partner interest in proforma net income         |       | 6                   |       |
| Limited partners’ interest in proforma net income       |       | $                   | 322        |   |
| Proforma net income per limited partner unit, basic          |       | $                   | 0.05       |   |
| Proforma net income per limited partner unit,  diluted       |       | $                   | 0.05       |   |
| Weighted average limited partner units outstanding,  basic   |       | 6,800,000           |       |
| Weighted average limited partner units outstanding,  diluted |       | 6,840,000           |       |

** **

**Note 3:  Propertyand Equipment**

 
| ** **                                      | ** ** | **As of**     | ** ** | **As of**        | ** ** |
|-------------------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **2006**      | ** ** | **2005**         | ** ** |
| Land                                            |       | $             | 225        |             | $          | 225 |   |
| Construction in progress                        |       | 11,224        |       | 3,676            |       |
| Pipeline and plants                             |       | 126,342       |       | 122,927          |       |
| Compression and water injection equipment       |       | 19,332        |       | 19,264           |       |
| Other                                           |       | 1,836         |       | 1,689            |       |
|                                            |       | 158,959       |       | 147,781          |       |
| Less: accumulated depreciation and amortization |       | 30,091        |       | 27,066           |       |
|                                            |       | $             | 128,868    |             | $          | 120,715 |   |
|                                                 |            |               |            |                  |            |  |  |  |  |

 

During the three months endedMarch 31, 2006, we capitalized interest of $101. Construction in progress atMarch 31, 2006, includes $124 of capitalized interest.

 

##### **Note 4:  Derivatives**

##### ** **

We have entered into certain financial swapinstruments that are classified as cash flow hedges in accordance with SFAS No.133, as amended, and relate to forecasted sales in 2006, 2007 and 2008. Weentered into these instruments to hedge forecasted natural gas and natural gasliquids (NGLs) sales or purchases against the variability in expected futurecash flows attributable to changes in commodity prices. Under all but one ofthese contractual swap agreements with our counterparties, we receive a fixedprice and pay a floating price based on certain indices for the relevantcontract period as the underlying natural gas or NGL is sold. In one agreement,we pay a fixed price and receive a floating price based on certain indices forthe relevant contract period as the underlying natural gas is purchased.

 

We formally document all relationships between hedginginstruments and the items being hedged, including our risk management objectiveand strategy for undertaking the hedging transactions. This includes matchingthe natural gas and NGL futures, the “sold fixed for floating price” or “buyfixed for floating price” contracts, to the forecasted transactions. We assess,both at the inception of the hedge and on an ongoing basis, whether thederivatives are highly effective in offsetting changes in the fair value ofhedged items. Highly effective is deemed to be a correlation range from 80% to125% of the change in cash flows of the derivative in offsetting the cash flowsof the hedged transaction. If it is determined that a derivative is not highlyeffective as a hedge or it has ceased to be a highly effective hedge, due tothe loss of correlation between changes in natural gas or natural gas liquidsreference prices under a hedging instrument and actual natural gas or naturalgas liquids prices, we will discontinue hedge accounting for the derivative andsubsequent changes in fair value for the derivative will be recognizedimmediately into earnings. We assess effectiveness using regression analysisand ineffectiveness using the dollar offset method.

 

Derivatives are recordedon our consolidated balance sheet as assets or liabilities at fair value. Forderivatives qualifying as

 

12

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hedges, the effective portion of changes in fair value are recognizedin owners’ equity as accumulated other comprehensive income and reclassified toearnings when the underlying hedged physical transaction closes. Fornon-qualifying derivatives and for the ineffective portion of qualifyingderivatives, changes in fair value are recognized in earnings as they occur.Actual amounts that will be reclassified will vary as a result of futurechanges in prices. Ineffective realized non-cash gains or losses are recordedin income while the hedge contract is open and may increase or decrease untilsettlement of the contract. Realized cash gains and losses on closedinstruments are reflected in the contract month being hedged as an adjustmentto our midstream revenue. During the three month period ended March 31, 2006 werecorded $184 in accumulated other comprehensive income for the change in fairvalue of derivative instruments and also recorded $82 as a realized non-cashgain on derivative transactions resulting from the ineffectiveness of ourhedges. We had no derivatives for the three months ended March 31, 2005. AtMarch 31, 2006 our accumulated other comprehensive income related toderivatives was $1,233. Of this amount we anticipate the $1,641 will bereclassified as a gain in earnings during the next twelve months and $408 willbe reclassified as a loss in earnings in subsequent periods.

 

The fair value of derivative assets and liabilitiesare as follows for the indicated periods:

 

| ** **                                       | ** ** | **As of**     | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2006**      | ** ** | **2005**         | ** ** |
| Fair value of derivative assets - current        |       | $             | 2,498      |             | $          | 868 |   |
| Fair value of derivative assets - long term      |       | 767           |       | 181              |       |
| Fair value of derivative liabilities - current   |       | (807          | )          | —           |       |
| Fair value of derivative liabilities - long term |       | (1,143        | )          | —           |       |
| Net fair value of derivatives                    |       | $             | 1,315      |             | $          | 1,049 |   |

##### ** **

The term of our derivative contracts extend out as faras March 2008. Our counterparty to all of our derivative contracts is BP EnergyCompany. Set forth below is the summarized notional amount and terms of allinstruments held for price risk management purposes at March 31, 2006.

 
| ** **                                          | ** ** | ** **  | ** ** | ** **            | ** ** | **Fair Value**  | ** ** |
|-----------------------------------------------------|------------|-------------|------------|-----------------------|------------|-----------------|------------|
| ** **                                          | ** ** | ** **  | ** ** | **Average**           | ** ** | **Asset**       | ** ** |
| **Description and Production  Period**              | ** ** | **Volume**  | ** ** | **Fixed Price**       | ** ** | **(Liability)** | ** ** |
| Natural Gas - Sold Fixed for Floating Swaps         |       |        |       |                  |       |            |       |
|                                                |       |        |       |                  |       |            |       |
| ** **                                          | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**  | ** ** | ** **      | ** ** |
| May 2006 - March 2007                               |       | 1,485,000   |       | $                     | 8.69       |            | $          | 2,498 |   |
| April 2007 - October 2007                           |       | 945,000     |       | $                     | 8.03       |            | 767        |   |
|                                                |       |        |       |                  |       | $               | 3,265      |   |
|                                                |       |        |       |                  |       |            |       |
| Natural Gas - Buy Fixed for Floating Swaps          |       |        |       |                  |       |            |       |
| ** **                                          | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**  | ** ** | ** **      | ** ** |
| September 2006 - March 2007                         |       | 350,000     |       | $                     | 8.87       |            | $          | (247 | ) |
| April 2007 - March 2008                             |       | 600,000     |       | $                     | 8.87       |            | (317       | ) |
|                                                |       |        |       |                  |       | $               | (564       | ) |
|                                                |       |        |       |                  |       |            |       |
| Natural Gas Liquids - Sold Fixed for Floating Swaps |       |        |       |                  |       |            |       |
| ** **                                          | ** ** | **(Bbl)**   | ** ** | **(per Gallon)** | ** ** | ** **      | ** ** |
| September 2006 - March 2007                         |       | 89,047      |       | $                     | 1.13       |            | $          | (559 | ) |
| April 2007 - March 2008                             |       | 152,652     |       | $                     | 1.13       |            | (827       | ) |
|                                                |       |        |       |                  |       | $               | (1,386     | ) |

 

13

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##### **Note 5:  Long-Term Debt**

 
| ** **            | ** ** | **As of**      | ** ** | **As of**        | ** ** |
|-----------------------|------------|----------------|------------|------------------|------------|
| ** **            | ** ** | **March 31,**  | ** ** | **December 31,** | ** ** |
| ** **            | ** ** | **2006­** | ** ** | **2005**         | ** ** |
| Note payable - bank   |       | $              | 41,784     |             | $          | 31,784 |   |
| Less: current portion |       | —         |       | —           |       |
| Long-term portion     |       | $              | 41,784     |             | $          | 31,784 |   |

 

On February 15, 2005,concurrently with the closing of our initial public offering, we entered into athree-year $55.0 million senior secured revolving credit facility.MidFirst Bank, a federally chartered savings association located in OklahomaCity, Oklahoma, is a lender and serves as administrative agent under thisfacility. The credit facility consisted of a $47.5 million senior securedrevolving credit facility to be used for funding acquisitions and other capitalexpenditures, issuance of letters of credit and general corporate purposes (the“revolving acquisition facility”) and a $7.5 million senior securedrevolving credit facility to be used for working capital and to funddistributions (the “revolving working capital facility”).

 

On September 26, 2005, concurrently with the acquisition ofHiland Partners, LLC, we amended our senior secured revolving creditfacility to increase our borrowing capacity under the facility from$55.0 million to $125.0 million, consisting of a $117.5 millionacquisition facility and a $7.5 million working capital facility. Thecredit facility will mature in February 2008. At that time, the agreement willterminate and all outstanding amounts thereunder will be due and payable. OnSeptember 26, 2005, we incurred $93.7 million of indebtedness underthe credit facility in connection with our acquisition of HilandPartners, LLC.

 

On November 21, 2005 wecompleted a public offering of our common units. We used $65.2 million of the$66.1 million net proceeds from the offering to repay a majority of the creditfacility borrowings we used to fund the acquisition of Hiland Partners, LLC. Theremaining acquisition facility available to us under the credit agreement atMarch 31, 2006 was $75.7 million. All of the $7.5 million working capitalfacility was available to us at March 31, 2006.

 

Our obligations under thecredit facility are collateralized by substantially all of our assets andguaranteed by us and all of our subsidiaries, other than our operating company,Hiland Operating, LLC, which is the borrower under the credit facility. Thecredit facility is non-recourse to our general partner.

 

Indebtedness under the creditfacility will bear interest, at our option, at either (i) an AlternateBase Rate plus an applicable margin ranging from 50 to 175 basis points perannum or (ii) LIBOR plus an applicable margin ranging from 150 to 275basis points per annum based on our ratio of total debt to EBITDA as defined inthe agreement. The Alternate Base Rate is a rate per annum equal to thegreatest of (a) the Prime Rate in effect on such day, (b) the base CDrate in effect on such day plus 1.50% and (c) the Federal Funds effectiverate in effect on such day plus one-half of 1%. A letterof credit fee will be payable for the aggregate amount of letters of creditissued under the credit facility at a percentage per annum equal to 1.0%. Anunused commitment fee ranging from 30 to 50 basis points per annum based on ourratio of total debt to EBITDA will be payable on the unused portion of thecredit facility.

 

The credit facility imposescertain requirements, including: prohibition against distributions tounitholders if, before or after the distributions, a potential default or anevent of default as defined in the agreement would occur; limitations on ourability to incur debt, grant liens, make loans, acquisitions, and investments,change the nature of our business, enter into a merger or consolidation, orsell assets, amend material agreements; and covenants that require maintenanceof certain levels of tangible net worth, EBITDA to interest expense ratio, anddebt to EBITDA ratio. If an event of default exists under the agreement, thelenders will be able to accelerate the maturity of the debt and exercise otherrights and remedies. As of March 31, 2006, we were in compliance with all ofthe covenants associated with our credit facility.

 

14

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**Note 6:  Commitmentsand Contingencies**

 

We have executed fixed pricephysical forward sales contracts on approximately 50,000 MMBtu per monththrough December 2007 with weighted average fixed prices per MMBtu of$4.47 and $4.49, respectively, for years 2006 through 2007. We also have fixedprice physical forward sales contracts to sell (1) approximately50,000 MMBtu of natural gas per month from April 2006 throughDecember 2006 with weighted average fixed prices per MMBtu of $9.52 and(2) approximately 50,000 MMBtu of natural gas per month fromJanuary 2007 through December 2007 with weighted average fixed pricesper MMBtu of $9.13. Such contracts have been designated as normal sales underSFAS No. 133 and are therefore not marked to market as derivatives.

 

We maintain a definedcontribution 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 endedMarch 31, 2006 and 2005 of $41 and $25, respectively.

 

We jointly participate withother affiliated companies in a self-insurance pool (the “Pool”) coveringhealth and workers’ compensation claims made by employees up to the first $150and $500, respectively, per claim. Any amounts paid above these are reinsuredthrough third party providers. Premiums charged to the Partnership are based onestimated costs per employee of the Pool. Property and general liabilityinsurance is maintained through third-party providers with a $100 deductible oneach policy.

 

The operation of pipelines, plants and other facilities for gathering,compressing, treating, or processing natural gas, NGLs and other products issubject to stringent and complex laws and regulations pertaining to health,safety and the environment. Our management believes that compliance withfederal, state or local environmental laws and regulations will not have amaterial adverse effect on our business, financial position or results ofoperations.

 

We are a party to variousregulatory proceedings and may from time to time be a party to litigation thatwe believe will not have a materially adverse impact on our financialcondition, results of operations or cash flows.

 

**Note 7:  SignificantCustomers and Suppliers**

** **

All of our revenues aredomestic revenues. The following table presents our top midstream customers asa percent of total revenue for the periods indicated:

 

| ** ** | ** ** | **For the Three  Months Ended  March 31,** | ** ** |
|------------|------------|--------------------------------------------|------------|
| ** ** | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Customer 1 |       | 19                                         | %          | 24 | % |
| Customer 2 |       | 18                                         | %          | — |   |
| Customer 3 |       | 13                                         | %          | — |   |
| Customer 4 |       | 12                                         | %          | — |   |
| Customer 5 |       | 9                                          | %          | 32 | % |
| Customer 6 |       | 7                                          | %          | 10 | % |
| Customer 7 |       | —                                     |       | 11 | % |

 

All of our purchases are fromdomestic sources. The following table presents our top midstream suppliers as apercent of total midstream purchases for the periods indicated

 

| ** **                      | ** ** | **For the Three  Months Ended  March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Supplier 1 (affiliated company) |       | 34                                         | %          | 30 | % |
| Supplier 2                      |       | 23                                         | %          | 34 | % |
| Supplier 3                      |       | 14                                         | %          | — |   |
| Supplier 4                      |       | 9                                          | %          | 16 | % |

 

15

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**Note 8:  RelatedParty Transactions**

** **

We purchase natural gas andNGLs from affiliated companies. Purchases of product totaled $14.4 millionand $6.3 million for the three months ended March 31, 2006 and 2005,respectively. We also sell natural gas and NGLs to affiliated companies. Salesof product totaled $1.3 million and $0.9 million for the three monthsended March 31, 2006 and 2005, respectively. Compression revenues fromaffiliates were $1.2 million and $0.6 million for the three monthsended March 31, 2006 and 2005, respectively.

 

Accounts receivable fromaffiliates of $1,170 at March 31, 2006 includes $1,030 from one affiliate formidstream sales. Accounts receivable from affiliates of $1,523 atDecember 31, 2005 includes $758 from the same affiliate for midstreamsales. 

 

Accounts payable toaffiliates of $4,628 at March 31, 2006 includes $4,428 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 utilize affiliatedcompanies to provide services to our plants and pipelines and certainadministrative costs. The total amount paid to these companies was $54 and $31during the three months ended March 31, 2006 and 2005, respectively.

 

We lease office space underoperating leases directly or indirectly from an affiliate. Rents paidassociated with these leases totaled $25 and $19 for the three months endedMarch 31, 2006 and 2005, respectively.

 

**Note 9:  Business Segments**

** **

On February 15, 2005,certain assets and liabilities of Hiland Partners, LLC were contributed to usin conjunction with our initial public offering. As a result of thistransaction, we have distinct operating segments for which additional financialinformation must be reported. Prior to February 15, 2005, we did not haveoperating segments. Our operations are now classified into two reportablesegments:

 

(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.

 

We evaluate the performanceof our segments and allocate resources to them based on operating income. Ouroperations are conducted in the United States.

 

Midstream assets totaled $163,826 at March 31,2006. Assets attributable to compression operations totaled $34,067. All but$68 of the total capital expenditures of $11,178 for the three months endedMarch 31, 2006 was attributable to midstream operations. 

 

The tables below presentinformation for the reportable segments for the three months ended March 31,2006 and 2005.

 

| ** **                                                       | ** ** | **For the Three Months Ended March 31, 2006** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                       | ** ** | **Midstream**                                 | ** ** | **Compression** | ** ** | **Total** | ** ** |
| Revenues                                                         |       | $                                             | 52,204     |   | $ | 1,205 |   | $ | 53,409 |   |
| Operating costs and expenses:                                    |       |                                          |       |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 41,535                                        |       | — |   | 41,535 |   |
| Operations and maintenance                                       |       | 2,386                                         |       | 188 |   | 2,574 |   |
| Depreciation and amortization                                    |       | 3,244                                         |       | 893 |   | 4,137 |   |
| General and administrative expenses                              |       | 1,007                                         |       | 23 |   | 1,030 |   |
| Total operating  costs and expenses                              |       | 48,172                                        |       | 1,104 |   | 49,276 |   |
| Income from operations                                           |       | $                                             | 4,032      |   | $ | 101 |   | 4,133 |   |
| Other income (expense):                                          |       |                                          |       |   |   |   |   |
| Interest and other income                                        |       |                                          |       |   |   | 75 |   |
| Amortization of deferred loan costs                              |       |                                          |       |   |   | (123 | ) |
| Interest expense                                                 |       |                                          |       |   |   | (535 | ) |
| Total other  income (expense)                                    |       |                                          |       |   |   | (583 | ) |
| Net income                                                       |       |                                          |       |   |   | $ | 3,550 |   |

 

16

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| ** **                                                              | ** ** | **For the Three Months Ended March 31, 2005** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                              | ** ** | **Midstream**                                 | ** ** | **Compression** | ** ** | **Total** | ** ** |
| Revenues                                                                |       | $                                             | 25,175     |   | $ | 603 |   | $ | 25,778 |   |
| Operating costs and expenses:                                           |       |                                          |       |   |   |   |   |
| Midstream  purchases (exclusive of items  shown  separately below) |       | 20,203                                        |       | — |   | 20,203 |   |
| Operations and maintenance                                              |       | 1,524                                         |       | 53 |   | 1,577 |   |
| Depreciation and amortization                                           |       | 1,379                                         |       | 298 |   | 1,677 |   |
| General and administrative expenses                                     |       | 337                                           |       | 16 |   | 353 |   |
| Total operating  costs and expenses                                     |       | 23,443                                        |       | 367 |   | 23,810 |   |
| Income from operations                                                  |       | $                                             | 1,732      |   | $ | 236 |   | 1,968 |   |
| Other income (expense):                                                 |       |                                          |       |   |   |   |   |
| Interest and other income                                               |       |                                          |       |   |   | 7 |   |
| Amortization of deferred loan costs                                     |       |                                          |       |   |   | (205 | ) |
| Interest expense                                                        |       |                                          |       |   |   | (134 | ) |
| Total other  income (expense)                                           |       |                                          |       |   |   | (332 | ) |
| Net income                                                              |       |                                          |       |   |   | $ | 1,636 |   |

 

**Note 10:  Net Income per Limited Partners’ Unit**

 

The computation of basic netincome per limited partners’ unit is based on the weighted-average number ofcommon and subordinated units outstanding during the period. Thecomputation of diluted earnings per unit further assumes the dilutive effect ofunit options and restricted units. Netincome per unit applicable to limited partners is computed by dividing netincome applicable to limited partners, after deducting the general partner’s 2%interest and incentive distributions, and after deducting net incomeattributable 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 of incomeper limited partner unit – basic and income per limited partnerunit – diluted assuming dilution for the three months ended March 31, 2006and 2005:

 
| ** **                                                     | ** ** | **Income**       | ** ** | ** **        | ** ** | ** **   | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|-------------------|------------|--------------|------------|
| ** **                                                     | ** ** | **Available to** | ** ** | ** **        | ** ** | ** **   | ** ** |
| ** **                                                     | ** ** | **Limited**      | ** ** | **Limited**       | ** ** | ** **   | ** ** |
| ** **                                                     | ** ** | **Partners**     | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                     | ** ** | **(Numerator)**  | ** ** | **(Denominator)** | ** ** | **Amount**   | ** ** |
| **For the Three Months Ended March 31, 2006**                  | ** ** | ** **       | ** ** | ** **        | ** ** | ** **   | ** ** |
| Income per limited partner unit -basic:                        |       |             |       |              |       |         |       |
| Income available to limited partners                           |       | $                | 3,164      |              |       |         | $          | 0.37 |   |
| Weighted average limited partner units outstanding             |       |             |       | 8,454,000         |       |         |       |
| Income per limited partner unit – diluted:                |       |             |       |              |       |         |       |
| Unit Options                                                   |       |             |       |              | 48,000     |         |       |   |
| Income available to limited partners plus assumed  conversions |       | $                | 3,164      |              | 8,502,000  |         | $          | 0.37 |   |
|                                                                |            |                  |            |                   |            |              |            |  |  |  |

 
| ** **                                                     | ** ** | **Income**            | ** ** | ** **             | ** ** | ** **        | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                     | ** ** | **Available to** | ** ** | ** **             | ** ** | ** **        | ** ** |
| ** **                                                     | ** ** | **Limited**           | ** ** | **Limited**            | ** ** | ** **        | ** ** |
| ** **                                                     | ** ** | **Partners**          | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                     | ** ** | **(Numerator)**       | ** ** | **(Denominator)**      | ** ** | **Amount**        | ** ** |
| **For the Three Months Ended March 31, 2005**                  | ** ** | ** **            | ** ** | ** **             | ** ** | ** **        | ** ** |
| Income per limited partner unit -basic:                        |       |                  |       |                   |       |              |       |
| Income available to limited partners                           |       | $                     | 1,120      |                   |       |              | $          | 0.16 |   |
| Weighted average limited partner units outstanding             |       |                  |       | 6,800,000              |       |              |       |
| Income per limited partner unit – diluted:                |       |                  |       |                   |       |              |       |
| Unit Options                                                   |       |                  |       | 40,000                 |       |              |       |
| Income available to limited partners plus assumed  conversions |       | $                     | 1,120      |                   | 6,840,000  |              | $          | 0.16 |   |

 

17

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**Note 11:  Partners’Capital and Cash Distributions**

 

Our unitholders (limitedpartners) have only limited voting rights on matters affecting our operationsand activities and, therefore, limited ability to influence our management’sdecisions regarding our business. Unitholders did not select our generalpartner or elect the board of directors of our general partner and effectivelyhave no right to select our general partner or elect its board of directors inthe future. Unitholders’ voting rights are further restricted by ourpartnership agreement provision providing that any units held by a person thatowns 20% or more of any class of units then outstanding, other than the generalpartner, its affiliates, their transferees and persons who acquired such unitswith the prior approval of the board of directors of our general partner,cannot be voted on any matter. In addition, our partnership agreement containsprovisions limiting the ability of our unitholders to call meetings or toacquire information about our operations, as well as other provisions limitinga unitholders’ ability to influence the manner or direction of our management

 

Our Partnership Agreementrequires that we distribute all of our cash on hand at the end of each quarter,less reserves established at our general partner’s discretion. We refer to thisas “available cash.” The amount of available cash may be greater than or lessthan the minimum quarterly distributions. In general, we will pay any cashdistribution made each quarter in the following manner:

 

•* *first, 98% to the common units and 2% to our general partner, until eachcommon unit has received a minimum quarterly distribution of $0.45 plus anyarrearages from prior quarters;

 

•* *second, 98% to the subordinated units and 2% to our general partner,until each subordinated unit has received a minimum quarterly distribution of$0.45; and

 

•* *third, 98% to all units pro rata, and 2% to our general partner, untileach unit has received a distribution of $0.495.

 

If cash distributions perunit exceed $0.495 in any quarter, our general partner will receive increasingpercentages, up to a maximum of 50% of the cash we distribute in excess of thatamount. We refer to these distributions as “incentive distributions.”

 

The distributions on thesubordinated units may be reduced or eliminated if necessary to ensure thecommon units receive their minimum quarterly distribution. Subordinated unitswill not accrue arrearages. The subordination period will end once we meetcertain 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.

 

Distributions paid by us to common and subordinatedunitholders, including amounts paid to affiliate owners and regular andincentive distributions paid to our general partner were as follows (inthousands, except per unit amounts):

 
| **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           | (a)        | 0.6500                      |       | 2,858      |       | 2,652            |       | 119                      |       | 315                 |       | 5,944            |       |
|               |       | $                           | 2.4750     |       | $          | 8,850            |       | $                        | 10,098     |                | $          | 398              |       | $ | 582 |   | $ | 19,928 |   |

 

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(a) This cash distribution was announced onApril 26, 2006 and will be paid on May 15, 2006 to all unitholders of record asof May 5, 2006.

 

**Note 12: Subsequent Events**

 

OnMay 1, 2006, we, through our wholly owned operating subsidiary, HilandOperating, LLC completed our acquisition of Enogex Gas Gathering, L.L.C.’sEastern Oklahoma gathering assets for $96.3 million in cash. The assets includefive separate low pressure natural gas gathering systems located in the EasternOklahoma Arkoma Basin that includes nearly 40,000 horsepower of compression andover 550 miles of natural gas gathering pipelines that are currently gatheringapproximately 145,000 Mcfd.

 

18

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Theacquisition was financed through the issuance of 761,714 common units to ourgeneral partner, Hiland Partners GP, LLC, at a per unit price of $45.03 perunit for a total of $35.0 million which includes the general partners’ 2%contribution and the remaining $61.3 million was financed through our bankrevolving credit facility. The price of the common units equaled the averageclosing price of the common units on the Nasdaq National Market for the threetrading days ended April 28, 2006. The common units were issued on May 10, 2006and are not entitled to receive the May 15, 2006 quarterly distribution. Theissuance of the common units to Hiland Partners GP, LLC was approved by theboard of directors, as well as the conflicts committee of the board ofdirectors, of our general partner.

 

19

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**HILANDPARTNERS, LP**

 

**Item 1A.Risk Factors**

 

Inaddition to the other information set forth in this report, you shouldcarefully consider the factors discussed in Part 1, Item 1A. “Risk Factors” inour Annual Report on Form 10-K for the year ended December 31, 2005, whichcould materially affect our business, financial condition or future results. Therisks described in our Annual Report on Form 10-K are not the only risks facingour Company. Additional risks and uncertainties not currently known to us orthat we currently deem to be immaterial also may materially adversely affectour business, financial condition and/ or operating results.

 

**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

QuarterlyReport on Form 10-Q.

 

**CautionaryStatement About Forward-Looking Statements**

 

ThisQuarterly Report on Form 10-Q includes certain “forward-looking statements”within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934.  These statementsinclude statements 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.

 

Ouractual results may differ materially from any results projected, forecasted,estimated or expressed in forward-looking statements since many of the factorsthat determine these results are subject to uncertainties and risks, difficultto predict, and beyond management’s control.  Such factors include:

 

•      the generaleconomic conditions in the United States of America as well as the generaleconomic conditions and currencies in foreign countries;

 

•      the continuedability to find and contract for new sources of natural gas supply;

 

•      the amount ofnatural gas transported on our gathering systems;

 

•      the level ofthroughput in our natural gas processing and treating facilities;

 

•      the fees wecharge and the margins realized for our services;

 

•      the prices andmarket demand for, and the relationship between, natural gas and NGLs;

 

**•**      energyprices generally;

 

•      the level ofdomestic oil and natural gas production;

 

•      theavailability of imported oil and natural gas;

 

•      actions takenby foreign oil and gas producing nations;

 

•      the politicaland economic stability of petroleum producing nations;

 

•      the weather inour operating areas;

 

•      the extent ofgovernmental regulation and taxation;

 

•      hazards oroperating risks incidental to the transporting, treating and processing ofnatural gas and NGLs that may not be fully covered by insurance;

 

•      competitionfrom other midstream companies;

 

•      loss of keypersonnel;

 

•      theavailability and cost of capital and our ability to access certain capitalsources;

 

•      changes in lawsand regulations to which we are subject, including tax, environmental,transportation and employment regulations;

 

•      the costs andeffects of legal and administrative proceedings;

 

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

 

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

 

These factors are not necessarily allof the important factors that could cause our actual results to differmaterially from those expressed in any of our forward-looking statements. Our future results will depend upon various other risks and uncertainties,

 

20

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including,but not limited to those described above.  Other unknown or unpredictablefactors also could have material adverse effects on our future results. You should not place undue reliance on any forward-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 Delaware limitedpartnership formed in October 2004 to own and operate the assets that hadhistorically been owned and operated by Continental Gas, Inc. (“CGI”) andHiland Partners, LLC.

 

CGI historically ownedall of our natural gas gathering, processing, treating and fractionation assetsother than our Worland and Bakken gathering systems. Hiland Partners, LLChistorically owned our Worland gathering system, our compression servicesassets and the Bakken gathering system. 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 with ourinitial public offering, the former owners of CGI and Hiland Partners, LLC andcertain of our affiliates, including our general partner, contributed to us,all of the assets and operations of CGI, other than a portion of its workingcapital assets, and substantially all of the assets and operations of HilandPartners, LLC, other than a portion of its working capital assets and theassets related to the Bakken gathering system, in exchange for an aggregate of720,000 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 our initialpublic offering of 2,300,000 common units on February 15, 2005, receivingnet proceeds of $48.1 million. The proceeds from the public offering wereused to (1) pay remaining offering costs of $2.2 million and deferreddebt issuance costs of $0.6 million, (2) pay outstanding indebtedness of$22.9 million, (3) redeem $6.3 million of common units from anaffiliate of Harold Hamm and the Hamm Trusts, and (4) make a $3.9 milliondistribution to the previous owners of Hiland Partners, LLC. We retained$12.2 million to replenish working capital.

 

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 this acquisition,Hiland Partners, LLC’s principal asset was the Bakken gatheringsystem located in eastern Montana.

 

Wecompleted a secondary public offering on November 21, 2005 whereby we issued1,630,000 common units, which included 30,000 over-allotment units, at anoffering price of $41.77 per common unit. Proceeds, including our generalpartner’s contribution of $1.4 million to maintain its 2.0% interest in us,totaled $66.1 million, net of the underwriter discount of $3.4 million. Offeringcosts incurred amounted to $0.6 million. We used $65.2 million of the proceedsto repay a portion of credit facility borrowings we had previously used to fundthe acquisition of Hiland Partners, LLC.

 

On May 1, 2006, wecompleted our acquisition of Enogex Gas Gathering, L.L.C.’s Eastern Oklahoma“Kinta” gathering assets for $96.3 million in cash.

 

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 our business and analyze and report our results of operationson a segment basis.  Our operations are divided into two businesssegments:

 

•      *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, dehydrating, and treating of natural gas andthe fractionation of NGLs.  This segment generated approximately 90% ofour total segment margin for the three months ended March 31, 2006.

 

•      *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 March 31, 2006, this segment generated approximately 10% ofour total segment margin.

 

Our midstream assets consistof thirteen natural gas gathering systems with approximately 1,700 milesof gas gathering pipelines, five natural gas processing plants, three naturalgas treating facilities and three NGL fractionation facilities. Our compressionassets consist of two air compression facilities and a water injection plant.

 

21

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The financial statements and financial information forthe three month period ended March 31, 2005 reflect the operations of CGI, ourpredecessor prior to February 15, 2005 and our operations from February 15,2005, the date of our initial public offering.

 

***Historical Resultsof Operations***

 

Our historical results of operations for the periods presented may notbe comparable, either from period to period or going forward, for the reasonsdescribed 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.

 

•      Our acquisitionof certain net assets from Hiland Partners, LLC in connection with our initialpublic offering was accounted for as a purchase and, as a result, these assetsare recorded at their fair value at the time of purchase, which occurredconcurrent with the closing of our initial public offering on February 15,2005.  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.

 

•      Our acquisitionof Hiland Partners, LLC on September 26, 2005 was accounted for as a purchaseexcept as described below.   As a result of 49% of the outstandingmembership interests of Hiland Partners, LLC being partially owned by acontrolling member of our general partner, 49% of the net assets of HilandPartners, LLC, for which estimated fair value was in excess of historicalbasis, have been recorded at historical cost and 51% of the assets have beenrecorded at fair value.  The results of operations from our Bakkengathering system, the primary asset of  Hiland Partners, LLC at the timeof this acquisition, are only reflected from September 1, 2005, our effectiveacquisition date.

 

**Results of Operations**

 

Set forth in the table below is financial andoperating data for our predecessor, CGI, and us for the periods indicated.Operations from our Worland gathering system and compression assets contributedto us by Hiland Partners, LLC are reflected only from February 15, 2005, thedate of our initial public offering.  Operations from our acquisition ofthe Bakken gathering system assets are reflected only from September 1, 2005.

 

22

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| ** **                                                              | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | ** **                       | ** ** | **2005** | ** ** |
| ** **                                                              | ** ** | ** **                       | ** ** | **Hiland** | ** ** | **Continental** | ** ** | ** ** | ** ** |
| ** **                                                              | ** ** | ** **                       | ** ** | **Partners,** | ** ** | **Gas, Inc.** | ** ** | ** ** | ** ** |
| ** **                                                              | ** ** | **2006**                         | ** ** | **LP (1)** | ** ** | **(Predecessor) (2)** | ** ** | **Total (3)** | ** ** |
| ** **                                                              | ** ** | ** **                       | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| **Total Segment Margin Data:**                                          | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream revenues                                                      |       | $                                | 52,204     |   | $ | 13,362 |   | $ | 11,813 |   | $ | 25,175 |   |
| Midstream purchases                                                     |       | 41,535                           |       | 10,456 |   | 9,747 |   | 20,203 |   |
| Midstream segment margin                                                |       | 10,669                           |       | 2,906 |   | 2,066 |   | 4,972 |   |
| Compression revenues (4)                                                |       | 1,205                            |       | 603 |   | — |   | 603 |   |
| Total segment margin (5)                                                |       | $                                | 11,874     |   | $ | 3,509 |   | $ | 2,066 |   | $ | 5,575 |   |
|                                                                    |       |                             |       |   |   |   |   |   |   |
| **Summary of Operations Data:**                                         | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream revenues                                                      |       | $                                | 52,204     |   | $ | 13,362 |   | $ | 11,813 |   | $ | 25,175 |   |
| Compression revenues                                                    |       | 1,205                            |       | 603 |   | — |   | 603 |   |
| Total revenues                                                          |       | 53,409                           |       | 13,965 |   | 11,813 |   | 25,778 |   |
|                                                                    |       |                             |       |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items  shown  separately below) |       | 41,535                           |       | 10,456 |   | 9,747 |   | 20,203 |   |
| Operations and maintenance                                              |       | 2,574                            |       | 797 |   | 780 |   | 1,577 |   |
| Depreciation, amortization and accretion                                |       | 4,137                            |       | 1,165 |   | 512 |   | 1,677 |   |
| General and administrative                                              |       | 1,030                            |       | 187 |   | 166 |   | 353 |   |
| Total operating costs and expenses                                      |       | 49,276                           |       | 12,605 |   | 11,205 |   | 23,810 |   |
| Operating income                                                        |       | 4,133                            |       | 1,360 |   | 608 |   | 1,968 |   |
| Other income (expense), net                                             |       | (583                             | )          | (217 | ) | (115 | ) | (332 | ) |
| **Net income**                                                          |       | 3,550                            |       | 1,143 |   | 493 |   | 1,636 |   |
|                                                                    |       |                             |       |   |   |   |   |   |   |
| Add:                                                                    |       |                             |       |   |   |   |   |   |   |
| Depreciation, amortization and accretion                                |       | 4,137                            |       | 1,165 |   | 512 |   | 1,677 |   |
| Amortization of deferred loan costs                                     |       | 123                              |       | 192 |   | 13 |   | 205 |   |
| Interest expense                                                        |       | 535                              |       | 26 |   | 108 |   | 134 |   |
|                                                                    |       |                             |       |   |   |   |   |   |   |
| **EBITDA (6)**                                                          |       | $                                | 8,345      |   | $ | 2,526 |   | $ | 1,126 |   | $ | 3,652 |   |
|                                                                    |       |                             |       |   |   |   |   |   |   |
| Operating Data:                                                         |       |                             |       |   |   |   |   |   |   |
| Natural gas sales (MMBTU/d)                                             |       | 59,627                           |       | 41,794 |   | 37,052 |   | 39,423 |   |
| NGL sales (Bbls/d)                                                      |       | 3,245                            |       | 1,428 |   | 1,206 |   | 1,317 |   |

 

----

(1) 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.

 

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

 

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

 

23

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

 

(5)Reconciliation of total segment margin to operating income:

 
| ** **                                                      | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                      | ** ** | ** **                       | ** ** | **2005** | ** ** |
| ** **                                                      | ** ** | ** **                       | ** ** | **Hiland** | ** ** | **Continental** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | ** **                       | ** ** | **Partners,** | ** ** | **Gas, Inc.** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **2006**                         | ** ** | **LP (5)** | ** ** | **(Predecessor) (1)** | ** ** | **Total (6)** | ** ** |
| ** **                                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Income** | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating income                                                |       | $                                | 4,133      |   | $ | 1,360 |   | $ | 608 |   | $ | 1,968 |   |
| Add:                                                            |       |                             |       |   |   |   |   |   |   |
| Operations and maintenance expenses                             |       | 2,574                            |       | 797 |   | 780 |   | 1,577 |   |
| Depreciation, amortization and accretion                        |       | 4,137                            |       | 1,165 |   | 512 |   | 1,677 |   |
| General and administrative expenses                             |       | 1,030                            |       | 187 |   | 166 |   | 353 |   |
| Total segment margin                                            |       | $                                | 11,874     |   | $ | 3,509 |   | $ | 2,066 |   | $ | 5,575 |   |

 

We viewtotal segment margin, a non-GAAP financial measure, as an important performancemeasure of the core profitability of our operations. We review total segmentmargin monthly for a 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 thirdparties. We define compression segment margin as the revenue derived from ourcompression segment.

 

(6) Wedefine EBITDA, a non-GAAP financial measure, as net income plus interestexpense, provisions for income taxes and depreciation, amortization andaccretion expense. EBITDA is used as a supplemental financial measure by ourmanagement and by external users of our financial statements such as investors,commercial banks, research analysts and others to assess: (1) the financialperformance of our assets without regard to financial methods, capitalstructure or historical cost basis; (2) the ability of our assets to generatecash sufficient to pay interest costs and support our indebtedness; (3) ouroperating performance and return on capital as compared to those of othercompanies in the midstream energy sector, without regard to financing orstructure; and (4) the viability of acquisitions and capital expenditureprojects and the overall rates of return on alternative investmentopportunities. EBITDA is also a financial measurement that, with certainnegotiated adjustments, is reported to our banks and is used as a gauge forcompliance with our financial covenants under our credit facility. EBITDAshould not be considered an alternative to net income, operating income, cashflows from operating activities or any other measure of financial performancepresented in accordance with GAAP.  Our EBITDA may not be comparable toEBITDA of similarly titled measures of other entities, as other entities may notcalculate EBITDA in the same manner as we do.

 

**Basis of Presentation**

 

WE ARE REQUIRED TO PRESENT, DISCUSS AND ANALYZE THE FINANCIAL CONDITIONAND RESULTS OF OPERATIONS FOR THE THREE MONTH PERIODS ENDED MARCH 31, 2005 ANDOUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE THREE MONTH PERIODSENDED MARCH 31, 2006, WHICH INCLUDES THE RESULTS OF OPERATIONS FOR THE WORLANDGATHERING SYSTEM AND COMPRESSION ASSETS ACQUIRED FROM HILAND PARTNERS, LLC ONFEBRUARY 15, 2005 AND THE RESULTS OF OPERATIONS FOR THE BAKKEN GATHERING SYSTEMASSETS ACQUIRED AS OF SEPTEMBER 1, 2005.

 

###### **ThreeMonths Ended March 31, 2006 Compared with Three Months Ended March 31, 2005**

###### ** **

***Revenues.***  Our revenues(midstream and compression) were $53.4 million for the three months ended March31, 2006 compared to $25.8 million for the three months ended March 31, 2005,an increase of $27.6 million, or 107.2%.  This increase was primarilyattributable to (1) increased volumes of approximately 14,000 MMBtu/day (MMBtuper day) of natural gas sales, and 1,750 Bbl/day (Bbls per day)of NGL sales,attributable to our acquisition of the Bakken gathering system effectiveSeptember 1, 2005, (2) additional volumes attributable to the Worland gatheringsystem which was contributed to us on February 15, 2005 (3) increased revenuesfrom compression assets contributed to us February 15, 2005 and (4) higheraverage realized natural gas prices and NGL sales prices.

 

24

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Our midstream revenues were $52.2 million for thethree months ended March 31, 2006 compared to $25.2 million for the threemonths ended March 31, 2005, an increase of $27.0 million, or 107.4%. Of thisincrease, $10.8 million was primarily attributable to higher average realizednatural gas prices and NGL sales prices and $16.2 million was attributable tohigher residue natural gas and NGL sales volumes. The volume increase isprimarily attributable to the Bakken gathering system we acquired effectiveSeptember 1, 2005 and the Worland gathering system acquired on February 15,2005.

 

Natural gas sales volumes were 59,627 MMBtu/d for thethree months ended March 31, 2006 compared to 39,423 MMBtu/d for the threemonths ended March 31, 2005, an increase of 20,204 MMBtu/d, or 51.2%.  Ofthe 20,204 MMBtu/d increase, 13,959, or 69.1% was attributable to the naturalgas volumes as a result of our Bakken gathering system acquisition effectiveSeptember 1, 2005. Our NGL sales volumes were 3,245 Bbls/d for the three monthsended March 31, 2006 compared to 1,317 Bbls/d for the three months ended March31, 2005, an increase of 1,928 Bbls/d, or 146.4%.  Of the 1,928 Bbls/dincrease, 1,743, or 90.4% was also attributable to our Bakken gathering system.These increases in volumes were also associated with additional volumes as aresult of our Worland gathering system acquisition on February 15, 2005.

 

Our average realized natural gas sales prices were$7.20 per MMBtu for the three months ended March 31, 2006 compared to $5.56 perMMBtu for the three months ended March 31, 2005, an increase of $1.64 perMMBtu, or 29.5%.  In addition, average realized NGL sales prices were$1.00 per gallon for the three months ended March 31, 2006 compared to $0.84per gallon for the three months ended March 31, 2005, an increase of $0.16 pergallon or 19.0%.  The change in our average realized natural gas and NGLsales prices was primarily a result of higher index prices due to a tighteningof supply and demand fundamentals for energy, which caused crude oil andnatural gas prices to rise during the three months ended March 31, 2006compared to the three months ended March 31, 2005.

 

Our compression revenues were $1.2 million for thethree months ended March 31, 2006 compared to $0.6 million for the three monthsended March 31, 2005, an increase of $.6 million, or 100.0%.  Thecompression assets were acquired on February 15, 2005, and accordingly, onlyinclude revenues for one half of the three months ended March 31, 2005.

 

***Midstream Purchases.***  Ourmidstream purchases were $41.5 million for the three months ended March 31,2006 compared to $20.2 million for the three months ended March 31, 2005, anincrease of $21.3 million, or 105.6%.  Of the $21.3 million increase,$11.3 million, or 52.3% was attributable to purchases as a result of our Bakkengathering system acquisition effective September 1, 2005. The increase is alsoattributable to higher average realized natural gas prices and NGL sales pricesand increased purchases resulting from our Worland gathering system acquisitionon February 15, 2005.

 

***Operations and Maintenance.***  Ouroperations and maintenance expense totaled $2.6 million for the three monthsended March 31, 2006 compared with $1.6 million for the three months endedMarch 31, 2005, an increase of $1.0 million, or 63.2%. Of this increase, $0.7million, or 68.7% was attributable to operations and maintenance at our Bakkengathering system. The increase is also attributable to operations andmaintenance at our Worland gathering system we acquired on February 15, 2005.

 

***Depreciation, Amortization and Accretion.*** Our depreciation, amortization and accretion expense totaled $4.1 million forthe three months ended March 31, 2006 compared with $1.7 million for the threemonths ended March 31, 2005, an increase of $2.5 million, or 146.7 %.  Ofthis increase, $1.7 million, or 70.9% was attributable to depreciation andamortization on our Bakken gathering system. The increase is also attributableto depreciation, amortization and accretion on our Worland gathering system andour compression assets we acquired on February 15, 2005.

 

***General and Administrative.***  Ourgeneral and administrative expense totaled $1.0 million for the three monthsended March 31, 2006 compared with $0.3 million for the three months endedMarch 31, 2005, an increase of $0.7 million, or 191.8%.  The increase isprimarily attributable to increased salaries and additional staffing of $0.3million and audit fees, tax preparation fees and additional costs of being apublic company of another $0.3 million.

 

***Other Income (Expense).*** Our otherincome (expense) totaled ($0.6) million for the three months ended March 31,2006 compared with ($0.3) million for the three months ended March 31, 2005, aincrease in expense of $0.3 million, or 75.6%.  The increase is primarilyattributable to additional interest expense associated with our credit facilityrelating to the acquisition of the Bakken gathering system effective September1, 2005.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

***Overview***

 

Cash generated from operations, borrowingsunder our credit facility and funds from private and public equity and debtofferings have historically been our primary sources of liquidity. We believethat funds from these sources should be sufficient to meet both our short-termworking capital requirements and our long-term capital expenditurerequirements. Our ability to pay distributions to our unitholders, to fundplanned capital expenditures and to make acquisitions depends upon our futureoperating performance, and more broadly, on the availability of equity and debtfinancing, which will be affected by prevailing economic conditions in ourindustry and financial, business and other factors, some of which are beyondour control.

 

25

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***Cash Flows fromOperating Activities***

 

Our cash flows from operating activities increased by$15.8 million to $9.0 million for the three months ended March 31, 2006 from$(6.8) million for the three months ended March 31, 2005.  We received cash flows from customers ofapproximately $59.6 million due to increased prices for natural gas and NGLsand higher volumes sold in the three months ended March 31, 2006, had cashpayments to our suppliers and employees of approximately $50.2 million and payment of interest expense in excess of interestreceived of $0.4 million, net of amounts capitalized, resulting in cashreceived from our operating activities of approximately $9.0 million. Changesin cash receipts and payments are primarily due to the timing of collections atthe end of our reporting periods. We collect and pay large receivables andpayables at the end of each calendar month and the timing of these payments andreceipts may vary by a day or two between month-end periods, and causefluctuations in cash received or paid. Increased natural gas and natural gasliquids prices together with the acquisition of the Bakken assets contributedto increases in accounts receivable, accrued midstream revenues, accountspayable and accrued midstream purchases during the three months ended March 31, 2006. Working capital items,exclusive of cash, contributed $1.1 million to cash flows from operatingactivities during the three months ended March 31, 2006 as compared to reducingcash flows from operating activities by $10.4 million for the three monthsended March 31, 2005. The use of cash from operating activities in 2005 wasprimarily a result of replenishing our accounts receivable after the closing ofthe initial public offering and increased accounts receivable as a result ofhigher realized prices for natural gas and NGLs. In connection with ourformation, the $9.1 million accounts receivables of CGI was retained by theformer owners of CGI. Net income for the three months ended March 31, 2006 was$3.5 million, an increase of $1.9 million from a net income of $1.6 million forthe three months ended March 31, 2005.  Our non-cash expenses increased$2.4 million in the first three months of 2006 compared with the same period in2005.

 

***Cash Flows Used forInvesting Activities***

 

Our cash flows used for investing activities, whichrepresent investments in property and equipment, increased by $10.9 million to$11.2 million for the three months ended March 31, 2006 from $0.3 million forthe three months ended March 31, 2005 largely due to the ongoing progress onour Badlands expansion project and continued growth at our Bakken gatheringsystem.

 

***Cash Flows fromFinancing Activities***

 

Our cash flows from financing activities decreased to$3.3 million for the three months ended March 31, 2006 from $10.1 million forthe three months ended March 31, 2005. During the three months ended March 31,2006, we borrowed $8.0 million under our credit facility to partially fund ourinternal expansion projects at both Badlands and Bakken. During the threemonths ended March 31, 2006, we received capital contributions of $0.9 millionas a result of issuing common units due to the exercise of 39,633 vested unitoptions. On February 14, 2006, we distributed $5.6 million to our unitholders. Wecompleted our initial 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 anddeferred debt issuance costs of $0.6 million, (2) pay outstanding indebtednessof $22.9 million, (3) redeem $6.3 million of common units from an affiliate ofHarold Hamm and the Hamm Trusts, and (4) make a $3.9 million distribution tothe previous owners of Hiland Partners, LLC.  We retained $12.2 million toreplenish working capital.  During the period from January 1, 2005 toFebruary 14, 2005, CGI repaid $1.1 million of its outstanding indebtedness.

 

***CapitalRequirements***

 

Our midstream energy business is capital intensive,requiring significant investment to maintain and upgrade existingoperations.  Our capital requirements have consisted primarily of, and weanticipate will continue to be:

 

•  maintenancecapital expenditures, which are capital expenditures made to replace partiallyor fully depreciated assets to maintain the existing operating capacity of ourassets and to extend their useful lives, or other capital expenditures that areincurred in maintaining existing 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 that cash generated from the operations ofour business will be sufficient to meet anticipated maintenance capitalexpenditures, which we have budgeted between $2.7 million and $3.3 million for2006.  We anticipate that expansion capital expenditures will be fundedthrough long-term borrowings or other debt financings and/or equityofferings.  See “Credit Facility” below for information related to ourcredit agreement.

 

***Kinta AssetsAcquisition***

 

OnMay 1, 2006, we, through our wholly owned operating subsidiary, HilandOperating, LLC completed our acquisition of Enogex Gas Gathering, L.L.C.’sEastern Oklahoma “Kinta” gathering assets for $96.3 million in cash. The Kintaassets include five separate low pressure natural gas gathering systems locatedin the Eastern Oklahoma Arkoma Basin that includes nearly 40,000

 

26

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horsepower of compressionand over 550 miles of natural gas gathering pipelines that are currentlygathering approximately 145,000 Mcfd.

 

Theacquisition was financed through the issuance of 761,714 common units to ourgeneral partner, Hiland Partners GP, LLC, at a per unit price of $45.03 perunit for a total of $35.0 million which includes the general partners’ 2%contribution and the remaining $61.3 million was financed through our bankrevolving credit facility. The price of the common units equaled the averageclosing price of the common units on the Nasdaq National Market for the threetrading days ended April 28, 2006. The common units were issued on May 10, 2006and will not be entitled to receive the quarterly distribution to be paid onMay 15, 2006. The issuance of the common units to Hiland Partners GP, LLC wasapproved by the board of directors, as well as the conflicts committee of theboard of directors, of our general partner.

 

***Badlands ExpansionProject***

 

On November 8, 2005, we entered into a new 15-yeardefinitive Gas Purchase Agreement with Continental Resources, Inc. under whichwe will gather, treat and process additional natural gas, which is produced asa by-product of Continental Resources’ secondary oil recovery operations, inthe areas specified by the contract.  In order to fulfill our obligationsunder the agreement, we intend to expand our Badlands gas gathering system andprocessing plant located in Bowman County, North Dakota.  This expansionproject will include the construction of a 40,000 Mcf/d nitrogen rejectionplant and the expansion of our existing Badlands field gatheringinfrastructure.  The expansion project, which is targeted for completionin the 4thquarter of 2006, is expected to cost approximately $40.0 million, which weintend to fund using our existing bank credit facility. As of March 31, 2006, we have invested $8.6million in the expansion project. Moreover, we expect to spend an additional$9.5 million in 2007 to expand the system.The cost to expand the system may exceed our expected costs if our assumptionsas to construction costs or other factors are incorrect or as a result of otherevents that are beyond our control.

 

***Bakken Compressors***

 

We have contractualobligations of $2.1 million to purchase three new compressors which we expectto be operational by the fourth quarter of 2006.

 

***FinancialDerivatives and Commodity Hedges***

 

We have entered into certainfinancial derivative instruments that are classified as cash flow hedges inaccordance with SFAS No. 133, as amended, and relate to forecasted sales in2006, 2007 and 2008. We entered into these instruments to hedge the forecastednatural gas and natural gas liquid sales or purchases against the variabilityin expected future cash flows attributable to changes in market prices. Theswap instruments are contractual agreements between counterparties to exchangeobligations of money as the underlying natural gas or natural gas liquids aresold or purchased. Under these swap agreements, we either receive or pay amonthly net settlement that is determined by the difference between a fixedprice and a floating price based on certain indices for the relevant contractperiod for the agreed upon volumes.

 

The following table provides information about thesefinancial derivative instruments for the periods indicated:

 

27

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| ** **                                  | ** ** | ** ** | ** ** | ** **      | ** ** | **Fair Value**  | ** ** |
|---------------------------------------------|------------|------------|------------|-----------------|------------|-----------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | **Average**     | ** ** | **Asset**       | ** ** |
| **Description and Production  Period**      | ** ** | **Volume** | ** ** | **Fixed Price** | ** ** | **(Liability)** | ** ** |
|                                        |       |       |       |            |       |            |       |
| Natural Gas - Sold Fixed for Floating Swaps |       |       |       |            |       |            |       |

 
| ** **                                 | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-------------|------------|----------------------|------------|------------|------------|
| May 2006 - March 2007                      |       | 1,485,000   |       | $                    | 8.69       |       | $          | 725 |   |
| April 2007 - October 2007                  |       | 945,000     |       | $                    | 8.03       |       | 2,540      |   |
|                                       |       |        |       |                 |       | $          | 3,265      |   |
|                                       |       |        |       |                 |       |       |       |
| Natural Gas - Buy Fixed for Floating Swaps |       |        |       |                 |       |       |       |

 
| ** **                                          | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|-------------|------------|----------------------|------------|------------|------------|
| September 2006 - March 2007                         |       | 350,000     |       | $                    | 8.87       |       | $          | (247 | ) |
| April 2007 - March 2008                             |       | 600,000     |       | $                    | 8.87       |       | (317       | ) |
|                                                |       |        |       |                 |       | $          | (564       | ) |
|                                                |       |        |       |                 |       |       |       |
| Natural Gas Liquids - Sold Fixed for Floating Swaps |       |        |       |                 |       |       |       |

 
| ** **                  | ** ** | **(Bbl)** | ** ** | **(per Gallon)** | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------|------------|-----------------------|------------|------------|------------|
| September 2006 - March 2007 |       | 89,047    |       | $                     | 1.13       |       | $          | (559 | ) |
| April 2007 - March 2008     |       | 152,652   |       | $                     | 1.13       |       | (827       | ) |
|                        |       |      |       |                  |       | $          | (1,386     | ) |

 

In addition to thecontractual obligations noted in the table above, as of March 31, 2006, we havefixed price forward sales contracts to sell (1) approximately 50,000 MMBtu ofnatural gas per month through December 2007 with weighted average fixedprices per MMBtu of $4.47 and $4.49, respectively, for years 2006 through 2007,(2) approximately 50,000 MMBtu of natural gas per month from April 1, 2006through December 2006 with weighted average fixed prices per MMBtu of$9.52 and (3) approximately 50,000 MMBtu of natural gas per month fromJanuary 2007 through December 2007 with weighted average fixed pricesper MMBtu of $9.13. Such contracts have been designated as normal sales underSFAS No. 133 and are therefore not marked to market as derivatives.

 

***Off-Balance SheetArrangements.***

 

We had no off-balance sheet arrangements as of March31, 2006.

 

***Credit Facility***

 

Concurrentlywith the closing of our initial public offering, we entered into a three-year$55.0 million senior secured revolving credit facility. MidFirst Bank, afederally chartered savings association located in Oklahoma City, Oklahoma, isa lender and serves as administrative agent under this facility. OnSeptember 26, 2005, concurrently with the closing of the Bakkenacquisition, we amended this facility to increase our borrowing capacity underthe facility to $125.0 million. On May 1, 2006, we, through our whollyowned operating subsidiary, Hiland Operating, LLC completed our acquisition ofEnogex Gas Gathering, L.L.C.’s Eastern Oklahoma gathering assets for $96.3million in cash. We used $61.3 million of our bank revolving credit facility topartially fund the acquisition. As of May 1, 2006 we have used a total of$103.1 million under our credit facility.

 

The facility currently consists of:

 

• a $117.5 millionsenior secured revolving credit facility to be used for funding acquisitionsand other capital expenditures, issuance of letters of credit and generalcorporate purposes (the “revolving acquisition facility”); and

 

• a $7.5 millionsenior secured revolving credit facility to be used for working capital and tofund distributions (the “revolving working capital facility”).

 

In addition, the revolving acquisition facility allowsfor the issuance of letters of credit of up to $5.0 million in theaggregate. The credit facility will mature in February 2008. At that time,the agreement will terminate and all outstanding amounts thereunder will be dueand payable.

 

Our obligations under the credit facility are securedby substantially all of our assets and guaranteed by us and all of oursubsidiaries, other than our operating company, which is the borrower under thecredit facility. The credit facility is non-recourse to our general partner.

 

Indebtedness under the credit facility will bearinterest, at our option, at either (i) an Alternate Base Rate plus anapplicable

 

28

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margin ranging from 50 to 175 basis points per annum or (ii) LIBORplus an applicable margin ranging from 150 to 275 basis points per annum basedon our ratio of total debt to EBITDA. The Alternate Base Rate is a rate perannum equal to the greatest of (a) the Prime Rate in effect on such day,(b) the base CD rate in effect on such day plus 1.50% and (c) theFederal Funds effective rate in effect on such day plus 1/2 of 1%. A letter ofcredit fee will be payable for the aggregate amount of letters of credit issuedunder the credit facility at a percentage per annum equal to 1.0%. An unusedcommitment fee ranging from 30 to 50 basis points per annum based on our ratioof total debt to EBITDA will be payable on the unused portion of the creditfacility.

 

The credit facility prohibits us from makingdistributions to unitholders if any default or event of default, as defined inthe credit facility, has occurred and is continuing or would result from thedistribution. In addition, the credit facility contains various covenants thatlimit, among other things, subject to certain exceptions and negotiated “baskets,”our ability to:

 

•  incur indebtedness;

 

•  grant liens;

 

•  make certain loans, acquisitions andinvestments;

 

•  make any material changes to the nature ofour business;

 

•  amend our material agreements, including theOmnibus Agreement; or

 

•  enter into a merger, consolidation or saleof assets.

 

The credit facility also contains covenants requiringus to maintain:

 

•  a maximum total debt to EBITDA ratio of4.0:1.0: and

 

•  a minimum interest coverage ratio of3.0:1.0; and

 

•  minimum tangible net worth of $40.

 

Upon the occurrence of an event of default under thecredit facility, the lenders may, among other things, be able to accelerate thematurity of the credit facility and exercise other rights and remedies as setforth in the credit facility. Each of the following will be an event ofdefault:

 

•  failure to pay any principal when due or anyinterest, fees or other amount within 3 business days of when due;

 

•  failure of any representation or warranty tobe true and correct in all material respects;

 

•  failure to perform or otherwise comply withthe covenants in the credit facility or other loan documents, in certain casessubject to certain grace periods;

 

•  default by us or any of our subsidiaries onthe payment of any other indebtedness in excess of $1.0 million, or anydefault in the performance of any obligation or condition with respect to suchindebtedness beyond the applicable grace period if the effect of the default isto permit or cause the acceleration of the indebtedness;

 

•  bankruptcy or insolvency events involvingus, our general partner or our subsidiaries;

 

•  material default by any party to anymaterial agreement, which is not cured within the time period specified in thematerial agreement for cure, that is reasonably expected to have a materialadverse effect;

 

•  the entry, and failure to pay or contest ingood faith, of one or more adverse judgments in an aggregate amount of $500,000or more in excess of third party insurance coverage;

 

•  a change of control (as defined in thecredit facility); and

 

•  invalidity of any loan documentation.

 

The credit facility limits distributions to ourunitholders to Available Cash, and borrowings to fund such distributions are

 

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only permitted under the revolving working capital facility. Therevolving working capital facility is subject to an annual “clean-down” periodof 15 consecutive days in which the amount outstanding under the revolvingworking capital facility is reduced to zero.

 

As of March 31, 2006, we had $41.8 millionoutstanding under the credit facility and were in compliance with our financial covenants.

 

***Impact of Inflation***

 

Inflation in the United States has been relatively lowin recent years and did not have a material impact on our results of operationsfor the periods presented.

 

**Recent Accounting Pronouncements**

 

In October 1995 the FASB issued SFAS No. 123, “Share-BasedPayment,” which was revised in December 2004 (collectively, “SFAS 123R”)FASB 123R requires 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, 2006 we recorded andunamortized 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 on theaccelerated attribution method. Units to be issued under our unit incentiveplan will result from newly issued units. Accordingly, no compensation expensewas recognized 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. We had 155,867 options outstanding as of March31, 2006.

 

**Significant Accounting Policies andEstimates**

 

The selection and application of accounting policiesis an important process that has developed as our business activities haveevolved and as the accounting rules have developed.  Accounting rulesgenerally do not involve a selection among alternatives, but involve theimplementation and interpretation of existing rules, and the use of judgmentapplied to the specific set of circumstances existing in our business.  Wemake every effort to properly comply with all applicable rules on or beforetheir adoption, and we believe the proper implementation and consistentapplication of the accounting rules are critical.  For further details onour accounting policies, you should read Note 1 of the accompanying Notes toFinancial 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 in June2000 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.

 

**Item 3.   Quantitativeand Qualitative Disclosures about Market Risk**

 

Market risk is the risk of loss arising from adversechanges in market rates and prices.  The principal market risk to which weare exposed is commodity price risk for natural gas and NGLs.  We alsoincur, to a lesser extent, risks related to interest rate fluctuations. We do not engage in commodity energy trading activities.

 

***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 thethree months ended March 31, 2006, the impact on our gross margin of a $0.01per gallon change (increase or

 

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decrease) in NGL prices coupled with a $0.10 per MMBtu change (increaseor decrease) in the price of natural gas.  The magnitude of the impact ontotal segment margin of changes in natural gas and NGL prices presented may notbe representative of the magnitude of the impact on total segment margin fordifferent commodity prices or contract portfolios.  Natural gas prices canalso affect our profitability indirectly by influencing the level of drillingactivity and related opportunities for our services.

 

| ** **         | ** ** | ** ** | ** ** | **Natural Gas Price Change ($/MMBtu)** | ** ** |
|--------------------|------------|------------|------------|----------------------------------------|------------|
|               |       |       |       |                                   |       |   |   |
|               |       |       |       | $                                      | 0.10       |   | $ | (0.10 | ) |
|               |       |       |       |                                   |       |   |   |
| **NGL Price**      |       | $          | 0.01       |                                   | $          | 108,000 |   | $ | (20,000 | ) |
| **Change ($/gal)** |       | $          | (0.01      | )                                      | $          | 20,000 |   | $ | (109,000 | ) |

 

We manage this commodity priceexposure through an integrated strategy that includes management of ourcontract portfolio, optimization of our assets and the use of derivativecontracts. As a result of these derivative swap contracts, we have hedged aportion of our expected exposure to natural gas prices and natural gas liquidsprices in 2006, 2007 and 2008. We continually monitor our hedging and contractportfolio and expect to continue to adjust our hedge position as conditionswarrant. The following table provides information about our derivativeinstruments for the periods indicated:

 
| ** **                                  | ** ** | ** ** | ** ** | ** **      | ** ** | **Fair Value**  | ** ** |
|---------------------------------------------|------------|------------|------------|-----------------|------------|-----------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | **Average**     | ** ** | **Asset**       | ** ** |
| **Description and Production  Period**      | ** ** | **Volume** | ** ** | **Fixed Price** | ** ** | **(Liability)** | ** ** |
|                                        |       |       |       |            |       |            |       |
| Natural Gas - Sold Fixed for Floating Swaps |       |       |       |            |       |            |       |

 
| ** **                                 | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|-------------|------------|----------------------|------------|------------|------------|
| May 2006 - March 2007                      |       | 1,485,000   |       | $                    | 8.69       |       | $          | 725 |   |
| April 2007 - October 2007                  |       | 945,000     |       | $                    | 8.03       |       | 2,540      |   |
|                                       |       |        |       |                 |       | $          | 3,265      |   |
|                                       |       |        |       |                 |       |       |       |
| Natural Gas - Buy Fixed for Floating Swaps |       |        |       |                 |       |       |       |

 
| ** **                                          | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|-------------|------------|----------------------|------------|------------|------------|
| September 2006 - March 2007                         |       | 350,000     |       | $                    | 8.87       |       | $          | (247 | ) |
| April 2007 - March 2008                             |       | 600,000     |       | $                    | 8.87       |       | (317       | ) |
|                                                |       |        |       |                 |       | $          | (564       | ) |
|                                                |       |        |       |                 |       |       |       |
| Natural Gas Liquids - Sold Fixed for Floating Swaps |       |        |       |                 |       |       |       |

 
| ** **                  | ** ** | **(Bbl)** | ** ** | **(per Gallon)** | ** ** | ** ** | ** ** |
|-----------------------------|------------|-----------|------------|-----------------------|------------|------------|------------|
| September 2006 - March 2007 |       | 89,047    |       | $                     | 1.13       |       | $          | (559 | ) |
| April 2007 - March 2008     |       | 152,652   |       | $                     | 1.13       |       | (827       | ) |
|                        |       |      |       |                  |       | $          | (1,386     | ) |

 

In addition to the derivativeinstruments noted in the table above, we have executed fixed price physicalforward sales contracts on approximately 50,000 MMBtu per month through December 2007with weighted average fixed prices per MMBtu of $4.47 and $4.49, respectively,for years 2006 through 2007. We also have fixed price physical forward salescontracts to sell (1) approximately 50,000 MMBtu of natural gas per monthfrom April 2006 through December 2006 with weighted average fixed pricesper MMBtu of $9.52 and (2) approximately 50,000 MMBtu of natural gas permonth from January 2007 through December 2007 with weighted averagefixed prices per MMBtu of $9.13. Such contracts have been designated as normalsales under SFAS No. 133 and are therefore not marked to market asderivatives.

 

***Interest Rate Risk*.**   We areexposed to changes in interest rates as a result of our credit facility, whichhas floating interest rates.  As of March 31, 2006, we had approximately$41.8 million of indebtedness outstanding under our credit facility.  OnMay 1, 2006 we borrowed $61.3 million to partially fund our Kinta assetsacquisition from Enogex Gas Gathering, L.L.C. The impact of a 100 basis pointincrease in interest rates on the amount of current debt would result in anincrease in interest expense, and a corresponding decrease in net income ofapproximately $1.0 million annually.

 

***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 three months ended March 31, 2006, accounted forapproximately 19.0%, 17.8%, 13.0% and 11.9%, respectively, of ourrevenues.  Consequently, changes within one or more of these companiesoperations have the potential to impact, both positively and negatively, ourcredit exposure. Our counterparty forour derivative instruments as of March 31, 2006 is BP Energy Company.

 

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**Item 4.   Controlsand Procedures**

 

**Evaluation of Disclosure Controls andProcedures**

 

(a)  Evaluation of disclosurecontrols and procedures.

 

Our principal executive officer and principal financial officer haveevaluated, as required by Rule 13a-15(b) under the Securities Exchange Actof 1934 (the “Exchange Act”), our disclosure controls and procedures (asdefined in Exchange Act Rule 13a-15(e)) as of the end of the period covered bythis quarterly report on Form 10-Q.   Based on that evaluation,the principal executive officer and principal financial officer concluded thatthe design and operation of our disclosure controls and procedures areeffective in ensuring that information we are required to disclose in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms.

 

(b) Changes in internal control over financial reporting.

 

There have been no changes in our internal control over financialreporting (as defined in Rule 13a-15(f) under the Exchange Act) thatoccurred during our last fiscal quarter that have materially affected or arereasonably likely to materially affect our internal control over financialreporting.

 

**PART II.OTHER INFORMATION**

 

**Item 1.Legal Proceedings**

 

We are a party to various legal and regulatory proceedings, none ofwhich we believe will have a material adverse impact on our financialcondition, results of operations or cash flows.

 

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

 

None.

 

**Item 3.Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5.Other Matters**

 

None.

 

**Item 6.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 the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized in thecity of Enid, Oklahoma, on the 12th day of May, 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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