Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****  QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FORTHE QUARTERLY PERIOD ENDED JUNE 30, 2008**

 

**OR**

 

**o****  TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**FORTHE TRANSITION PERIODFROM             TO**

 

**Commissionfile number:  000-51120**

 

**HilandHoldings GP, LP**

(Exact name ofRegistrant as specified in its charter)

 

| **DELAWARE**                              | ** ** | **76-0828238**       |
|-------------------------------------------|------------|----------------------|
| (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)           |

 

**(580)242-6040**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 day  x  Yes   o  No

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company. See definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act:

 
|   |   | Large accelerated filer o |   | Non-accelerated filer o    |   | Accelerated filer x |   | Smaller reporting company o |
|--------|--------|---------------------------|--------|----------------------------|--------|---------------------|--------|-----------------------------|
|   |   |                      |   | (Do not check if a smaller |   |                |   |                        |
|   |   |                      |   | reporting company)         |   |                |   |                        |

 

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

 

The number of theregistrant’s outstanding equity units as of August 6, 2008 was 21,603,000common units.

 

 

** **

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**HILAND****HOLDINGS GP****, LP**

**INDEX**

 
|                                                                                                      | **Page**   |
|------------------------------------------------------------------------------------------------------|------------|
| **PART I. FINANCIAL INFORMATION**                                                               | ** ** |
| Item 1. Financial Statements (Unaudited, except  December 31, 2007 Balance Sheet)               |       |
| Consolidated Balance Sheets                                                                          | 2          |
| Consolidated Statements of Operations                                                                | 3          |
| Consolidated Statements of Cash Flows                                                                | 4          |
| Consolidated Statement of Changes in Partners’ Equity  and Comprehensive Income (Loss)          | 5          |
| Condensed Notes to Consolidated Financial Statements                                                 | 6          |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 26         |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risks                                 | 42         |
| Item 4. Controls and Procedures                                                                      | 43         |
| **PART II.  OTHER INFORMATION**                                                                 | 43         |
| Item  1. Legal Proceedings                                                                           | 43         |
| Item 1A. Risk Factors                                                                                | 44         |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                 | 44         |
| Item 3. Defaults Upon Senior Securities                                                              | 45         |
| Item 4. Submission of Matters to a Vote of Security  Holders                                         | 45         |
| Item  5. Other Information                                                                           | 45         |
| Item 6. Exhibits                                                                                     | 45         |
| SIGNATURES                                                                                           | 46         |
| Certification of CEO under Section 302                                                          |       |
| Certification of CFO under Section 302                                                          |       |
| Certification of CEO under Section 906                                                          |       |
| Certification of CFO under Section 906                                                          |       |

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedBalance Sheets**

 
| ** **                                                      | ** ** | **June 30,**                                           | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2008**                                                    | ** ** | **2007**              | ** ** |
| ** **                                                      | ** ** | **(unaudited)**                                             | ** ** | ** **            | ** ** |
| ** **                                                      | ** ** | **(in thousands, except unit amounts)** | ** ** |
| **ASSETS**                                                      |       |                                                        |       |                  |       |
| **Current  assets:**                                            |       |                                                        |       |                  |       |
| Cash and cash  equivalents                                      |       | $                                                           | 13,793     |                  | $          | 10,602 |   |
| Accounts  receivable:                                           |       |                                                        |       |                  |       |
| Trade-net of  allowance for doubtful accounts of $8,103 in 2008 |       | 45,728                                                      |       | 31,842                |       |
| Affiliates                                                      |       | 2,951                                                       |       | 1,178                 |       |
|                                                            |       | 48,679                                                      |       | 33,020                |       |
| Fair value of  derivative assets                                |       | 1,483                                                       |       | 2,718                 |       |
| Other current  assets                                           |       | 2,371                                                       |       | 1,420                 |       |
| Total current  assets                                           |       | 66,326                                                      |       | 47,760                |       |
|                                                            |       |                                                        |       |                  |       |
| Property and  equipment, net                                    |       | 326,005                                                     |       | 323,073               |       |
| Intangibles, net                                                |       | 43,859                                                      |       | 46,937                |       |
| Fair value of  derivative assets                                |       | —                                                      |       | 418                   |       |
| Other assets,  net                                              |       | 2,266                                                       |       | 2,098                 |       |
|                                                            |       |                                                        |       |                  |       |
| **Total  assets**                                               |       | $                                                           | 438,456    |                  | $          | 420,286 |   |
|                                                            |       |                                                        |       |                  |       |
| **LIABILITIES  AND PARTNERS’ EQUITY**                      | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| **Current  liabilities:**                                       |       |                                                        |       |                  |       |
| Accounts payable                                                |       | $                                                           | 34,024     |                  | $          | 24,713 |   |
| Accounts  payable-affiliates                                    |       | 15,411                                                      |       | 7,957                 |       |
| Fair value of  derivative liabilities                           |       | 11,785                                                      |       | 8,238                 |       |
| Accrued  liabilities and other                                  |       | 3,162                                                       |       | 2,075                 |       |
| Total current  liabilities                                      |       | 64,382                                                      |       | 42,983                |       |
|                                                            |       |                                                        |       |                  |       |
| Commitments and  contingencies (Note 8)                         |       |                                                        |       |                  |       |
| Long-term debt                                                  |       | 245,150                                                     |       | 226,459               |       |
| Fair value of  derivative liabilities                           |       | 2,045                                                       |       | 141                   |       |
| Asset retirement  obligation                                    |       | 2,322                                                       |       | 2,159                 |       |
| Minority  interests                                             |       | 117,241                                                     |       | 126,409               |       |
|                                                            |       |                                                        |       |                  |       |
| **Partners’  equity**                                      |       |                                                        |       |                  |       |
| Common  unitholders (21,603,000 units issued and outstanding)   |       | 13,803                                                      |       | 25,560                |       |
| Accumulated  other comprehensive loss                           |       | (6,487                                                      | )          | (3,425                | )          |
| **Total  partners’ equity**                                |       | 7,316                                                       |       | 22,135                |       |
|                                                            |       |                                                        |       |                  |       |
| **Total  liabilities and partners’ equity**                |       | $                                                           | 438,456    |                  | $          | 420,286 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Statements of Operations**

**For theThree and Six Months Ended (unaudited)**

 
| ** **                                                                             | ** ** | **Three Months Ended June 30,**                  | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2008**                                                             | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                             | ** ** | **(in thousands, except per unit amounts)** | ** ** |
| **Revenues:**                                                                          |       |                                                                 |       |                                              |       |   |   |   |   |
| Midstream  operations                                                                  |       |                                                                 |       |                                              |       |   |   |   |   |
| Third parties                                                                          |       | $                                                                    | 112,214    |                                              | $          | 64,664 |   | $ | 201,467 |   | $ | 123,523 |   |
| Affiliates                                                                             |       | 2,022                                                                |       | 747                                               |       | 3,043 |   | 1,736 |   |
| Compression  services, affiliate                                                       |       | 1,205                                                                |       | 1,205                                             |       | 2,410 |   | 2,410 |   |
| Total revenues                                                                         |       | 115,441                                                              |       | 66,616                                            |       | 206,920 |   | 127,669 |   |
| **Operating  costs and expenses:**                                                     |       |                                                                 |       |                                              |       |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below)                       |       | 51,191                                                               |       | 34,908                                            |       | 93,642 |   | 66,789 |   |
| Midstream  purchases -affiliate (exclusive of items shown separately below)            |       | 36,882                                                               |       | 13,008                                            |       | 63,049 |   | 24,742 |   |
| Operations and  maintenance                                                            |       | 7,551                                                                |       | 4,980                                             |       | 14,320 |   | 9,950 |   |
| Depreciation,  amortization and accretion                                              |       | 9,456                                                                |       | 7,326                                             |       | 18,671 |   | 14,352 |   |
| Bad debt                                                                               |       | 8,103                                                                |       | —                                            |       | 8,103 |   | — |   |
| General and  administrative expenses                                                   |       | 2,333                                                                |       | 2,285                                             |       | 5,018 |   | 4,330 |   |
| Total operating  costs and expenses                                                    |       | 115,516                                                              |       | 62,507                                            |       | 202,803 |   | 120,163 |   |
| Operating income  (loss)                                                               |       | (75                                                                  | )          | 4,109                                             |       | 4,117 |   | 7,506 |   |
| **Other  income (expense):**                                                           |       |                                                                 |       |                                              |       |   |   |   |   |
| Interest and  other income                                                             |       | 73                                                                   |       | 93                                                |       | 177 |   | 219 |   |
| Amortization of  deferred loan costs                                                   |       | (168                                                                 | )          | (110                                              | )          | (324 | ) | (220 | ) |
| Interest expense                                                                       |       | (3,130                                                               | )          | (2,314                                            | )          | (6,636 | ) | (4,405 | ) |
| Other income  (expense), net                                                           |       | (3,225                                                               | )          | (2,331                                            | )          | (6,783 | ) | (4,406 | ) |
| **Income  (loss) before minority interest in****loss (income) of Hiland Partners, LP** |       | (3,300                                                               | )          | 1,778                                             |       | (2,666 | ) | 3,100 |   |
| Minority interest  in loss (income) of Hiland  Partners, LP                            |       | 2,192                                                                |       | (639                                              | )          | 2,398 |   | (1,213 | ) |
| **Net  income (loss)**                                                                 |       | $                                                                    | (1,108     | )                                                 | $          | 1,139 |   | $ | (268 | ) | $ | 1,887 |   |
|                                                                                   |       |                                                                 |       |                                              |       |   |   |   |   |
| **Net  income (loss) per limited****partners’ unit - basic**                      |       | $                                                                    | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.01 | ) | $ | 0.09 |   |
| **Net  income (loss) per limited****partners’ unit - diluted**                    |       | $                                                                    | (0.05      | )                                                 | $          | 0.05 |   | $ | (0.01 | ) | $ | 0.09 |   |
| **Weighted  average limited partners’****units outstanding - basic**              |       | 21,603                                                               |       | 21,600                                            |       | 21,603 |   | 21,600 |   |
| **Weighted  average limited partners’****units outstanding - diluted**            |       | 21,603                                                               |       | 21,606                                            |       | 21,603 |   | 21,606 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedStatements of Cash Flows**

**For the Six Months Ended (unaudited)**

 
| ** **                                                                         | ** ** | **June 30,**       | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **2008**                | ** ** | **2007**          | ** ** |
| ** **                                                                         | ** ** | **(in thousands)** | ** ** |
| **Cash  flows from operating activities:**                                         |       |                    |       |              |       |
| Net income  (loss)                                                                 |       | $                       | (268       | )                 | $          | 1,887 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                    |       |              |       |
| Depreciation and  amortization                                                     |       | 18,605                  |       | 14,299            |       |
| Accretion of  asset retirement obligation                                          |       | 66                      |       | 53                |       |
| Amortization of  deferred loan cost                                                |       | 324                     |       | 220               |       |
| Loss (gain) on  derivative transactions                                            |       | 1,935                   |       | (171              | )          |
| Unit based  compensation                                                           |       | 840                     |       | 756               |       |
| Bad debt                                                                           |       | 8,103                   |       | —            |       |
| Increase in  other assets                                                          |       | (146                    | )          | —            |       |
| Minority  interest in income (loss) of Hiland Partners, LP                         |       | (2,398                  | )          | 1,213             |       |
| (Increase)  decrease in current assets:                                            |       |                    |       |              |       |
| Accounts  receivable – trade-net                                              |       | (21,989                 | )          | (1,709            | )          |
| Accounts  receivable - affiliates                                                  |       | (1,773                  | )          | 345               |       |
| Other current  assets                                                              |       | (951                    | )          | (232              | )          |
| Increase  (decrease) in current liabilities:                                       |       |                    |       |              |       |
| Accounts payable  – trade                                                     |       | 11,218                  |       | 1,962             |       |
| Accounts payable  - affiliates                                                     |       | 7,454                   |       | 563               |       |
| Accrued  liabilities and other                                                     |       | 1,013                   |       | 5                 |       |
| **Net  cash provided by operating activities**                                     |       | 22,033                  |       | 19,191            |       |
| **Cash  flows from investing activities:**                                         |       |                    |       |              |       |
| Additions to  property and equipment                                               |       | (20,276                 | )          | (36,715           | )          |
| Proceeds from  disposals of property and equipment                                 |       | 6                       |       | —            |       |
| **Net  cash used in investing activities**                                         |       | (20,270                 | )          | (36,715           | )          |
| **Cash  flows from financing activities:**                                         |       |                    |       |              |       |
| Proceeds from  long-term borrowings                                                |       | 19,000                  |       | 30,601            |       |
| Increase in deferred  offering cost                                                |       | (7                      | )          | (142              | )          |
| Debt issuance  costs                                                               |       | (339                    | )          | (2                | )          |
| Proceeds from  Hiland Partners, LP unit options exercise                           |       | 1,031                   |       | 1,024             |       |
| Redemption of  vested phantom units                                                |       | (35                     | )          | —            |       |
| Payments on  capital lease obligations                                             |       | (235                    | )          | —            |       |
| Minority interest  cash distributions to unitholders of Hiland Partners, LP        |       | (6,421                  | )          | (5,565            | )          |
| Cash  distributions to unitholders                                                 |       | (11,566                 | )          | (8,969            | )          |
| **Net  cash provided by financing activities**                                     |       | 1,428                   |       | 16,947            |       |
|                                                                               |       |                    |       |              |       |
| Increase  (decrease) for the period                                                |       | 3,191                   |       | (577              | )          |
| Beginning of  period                                                               |       | 10,602                  |       | 10,569            |       |
| **End of  period**                                                                 |       | $                       | 13,793     |              | $          | 9,992 |   |
| Supplementary  information                                                         |       |                    |       |              |       |
| Cash paid for  interest, net of amounts capitalized                                |       | $                       | 6,437      |              | $          | 4,397 |   |

 

The accompanying notes are an integral part of these consolidated financialstatements

 

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**HilandHoldings GP, LP**

**Consolidated Statement of Changes in Partners’ Equity andComprehensive Income (Loss)**

**For the SixMonths Ended June 30, 2008 (unaudited)**

 
| ** **                                                                           | ** ** | ** **         | ** ** | **Accumulated**        | ** ** | ** ** | ** ** | ** **             | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|------------|------------|------------------------|------------|
| ** **                                                                           | ** ** | **Common**         | ** ** | **Other**              | ** ** | ** ** | ** ** | **Total**              | ** ** |
| ** **                                                                           | ** ** | **Unitholders**    | ** ** | **Comprehensive**      | ** ** | ** ** | ** ** | **Comprehensive**      | ** ** |
| ** **                                                                           | ** ** | **Interest**       | ** ** | **Income (loss)** | ** ** | **Total**  | ** ** | **Income (Loss)** | ** ** |
| ** **                                                                           | ** ** | **(in thousands)** | ** ** |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| **Balance  January 1, 2008**                                                    |       | $                  | 25,560     |                   | $          | (3,425     | )          | $                      | 22,135     |   |   |   |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| Periodic cash  distributions                                                         |       | (11,566            | )          | —                 |       | (11,566    | )          |                   |       |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| Unit based  compensation                                                             |       | 77                 |       | —                 |       | 77         |       |                   |       |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| Other  comprehensive income reclassified to income on closed derivative transactions |       | —             |       | 3,043                  |       | 3,043      |       | $                      | 3,043      |   |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| Change in fair  value of derivatives                                                 |       | —             |       | (6,105                 | )          | (6,105     | )          | (6,105                 | )          |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| Net income  (loss)                                                                   |       | (268               | )          | —                 |       | (268       | )          | (268                   | )          |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| Comprehensive  income (loss)                                                         |       |               |       |                   |       |       |       | $                      | (3,330     | ) |
|                                                                                 |       |               |       |                   |       |       |       |                   |       |
| **Balance  June 30, 2008**                                                      |       | $                  | 13,803     |                   | $          | (6,487     | )          | $                      | 7,316      |   |   |   |

 

The accompanying notes are anintegral part of this consolidated financial statement.

 

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**HILANDHOLDINGS GP, LP**

**CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS (UNAUDITED)**

**THREEAND SIX MONTHS ENDED JUNE 30, 2008 and 2007**

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

 

**Note 1: Organization, Basis of Presentation andPrinciples of Consolidation**

 

Unless the contextrequires otherwise, references to “we”, “our,” “us,” “Hiland Holdings” or “thePartnership” are intended to mean the consolidated business and operations ofHiland Holdings GP, LP. References to “Hiland Partners” are intended to meanthe consolidated business and operations of Hiland Partners, LP and itssubsidiaries.

 

Hiland Holdings GP, LP, aDelaware limited partnership, was formed in May 2006 to own HilandPartners GP, LLC, the general partner of Hiland Partners, LP and certain othercommon and subordinated units in Hiland Partners. Hiland Partners GP, LLC wasformed in October 2004 to hold the 2% general partner ownership interestin Hiland Partners and serve as its general partner. Hiland Partners GP, LLCmanages the operations of Hiland Partners. In connection with the closing ofour initial public offering, all of the membership interests in Hiland PartnersGP, LLC were contributed to us. Hiland Partners GP, LLC constitutes ourpredecessor.

 

Our general partner,Hiland Partners GP Holdings, LLC manages our operations and activities,including, among other things, paying our expenses and establishing thequarterly cash distribution levels for our common units and reserves that ourgeneral partner determines, in good faith, are necessary or appropriate toprovide for the conduct of our business, to comply with applicable law, any ofour debt instruments or other agreements or to provide for future distributionsto our unitholders for any one or more of the upcoming four quarters.

 

Hiland Partners, aDelaware limited partnership, was formed in October 2004 to acquire andoperate certain midstream natural gas plants, gathering systems and compressionand water injection assets located in the states of Oklahoma, North Dakota,Wyoming, Texas and Mississippi that were previously owned by Continental Gas, Inc.and Hiland Partners, LLC. Hiland Partners commenced operations on February 15,2005, and concurrently with the completion of its initial public offering,Continental Gas, Inc. contributed a substantial portion of its net assetsto Hiland Partners. The transfer of ownership of net assets from ContinentalGas, Inc. to Hiland Partners represented a reorganization of entitiesunder common control and was recorded at historical cost. Continental Gas, Inc.was formed in 1990 as a wholly owned subsidiary of Continental Resources, Inc.

 

Continental Gas, Inc.operated in one segment, midstream, which involved the purchasing, gathering,compressing, dehydrating, treating, processing and marketing of natural gas andfractionating and marketing of natural gas liquids, or NGLs. Continental Gas, Inc.historically has owned all of Hiland Partners’ natural gas gathering,processing, treating and fractionation assets other than the Worland,  Bakken and Woodford Shale gathering systems.Hiland Partners, LLC historically owned the Worland gathering system and compressionservices assets, which Hiland Partners acquired on February 15, 2005, andthe Bakken gathering system. Since its initial public offering, Hiland Partnershas operated in midstream and compression services segments. On September 26,2005, Hiland Partners acquired Hiland Partners, LLC, which at such time ownedthe Bakken gathering system, for $92.7 million, $35.0 million ofwhich was used to retire outstanding Hiland Partners, LLC indebtedness. On May 1,2006, Hiland Partners acquired the Kinta Area gathering assets from Enogex GasGathering, L.L.C., consisting of certain eastern Oklahoma gas gatheringassets, for $96.4 million.  HilandPartners financed this acquisition with $61.2 million of borrowings from itscredit facility and $35.0 million of proceeds from the issuance to HilandPartners GP, LLC, its general partner, of 761,714 common units and 15,545general partner equivalent units, both at $45.03 per unit. Hiland Partnersbegan construction of the Woodford Shale gathering system in the first quarterof 2007.  As of June 30, 2008,Hiland Partners has invested approximately $29.4 million in the gatheringsystem.

 

The unaudited financialstatements for thethree and six months ended June 30, 2008 and 2007 included herein havebeen prepared pursuant to the rules and regulations of the United StatesSecurities and Exchange Commission (the “SEC”). The interim financialstatements reflect all adjustments, which in the opinion of our management, arenecessary for a fair presentation of our results for the interim periods. Suchadjustments are considered to be of a normal recurring nature. Results ofoperations for the three and six months ended June 30, 2008 are notnecessarily indicative of the results of operations that will be realized forthe year ending December 31, 2008. The accompanying consolidated financial statements and notes theretoshould be read in conjunction with the consolidated financial statements andnotes thereto included in our Form 10-K for the fiscal year ended December 31,2007.

 

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***Principles ofConsolidation***

 

Because we own thegeneral partner of Hiland Partners, the consolidated financial statementsinclude our accounts, the accounts of Hiland Partners GP, LLC and the accountsof Hiland Partners and its subsidiaries. All significant intercompanytransactions and balances have been eliminated.

 

***Use of Estimates***

 

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

 

***Fair Value of Financial Instruments***

 

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

 

***Commodity Risk Management***

 

We engage in price riskmanagement activities in order to minimize the risk from market fluctuation inthe prices of natural gas and NGLs. To qualify as an accounting hedge, theprice movements in the commodity derivatives must be highly correlated with theunderlying hedged commodity. Gains and losses related to commodity derivativesthat qualify as accounting hedges are recognized in income when the underlyinghedged physical transaction closes and are included in the consolidatedstatements of operations as revenues from midstream operations. Gains andlosses related to commodity derivatives that are not designated as accountinghedges or do not qualify as accounting hedges are recognized in incomeimmediately, and are included in revenues from midstream operations in theconsolidated statement of operations.

 

SFAS 133 establishesaccounting and reporting standards for derivative instruments, includingcertain derivative instruments embedded in other contracts, and for hedgingactivities. SFAS 133 requires that an entity recognize all derivatives aseither assets or liabilities in the statement of financial position and measurethose instruments at fair value. However, if a derivative does qualify forhedge accounting, depending on the nature of the hedge, changes in fair valuecan be offset against the change in fair value of the hedged item throughearnings or recognized in other comprehensive income (loss) until such time asthe hedged item is recognized in earnings. To qualify for cash flow hedgeaccounting, the cash flows from the hedging instrument must be highly effectivein offsetting changes in cash flows due to changes in the underlying item beinghedged. In addition, all hedging relationships must be designated, documentedand reassessed periodically. SFAS 133 also provides that normal purchases andnormal sales contracts are not subject to the statement. Normal purchases and normalsales are contracts that provide for the purchase or sale of something otherthan a financial instrument or derivative instrument that will be delivered inquantities expected to be used or sold by the reporting entity over areasonable period in the normal course of business. Our fixed price physicalforward natural gas sales contract in which we have contracted to sell naturalgas quantities at a fixed price is designated as a normal sale. This forwardsales contract expires on December 31, 2008.

 

Currently, our derivativefinancial instruments that qualify for hedge accounting are designated as cashflow hedges. The cash flow hedge instruments hedge the exposure of variabilityin expected future cash flows that is attributable to a particular risk. Theeffective portion of the gain or loss on these derivative instruments isrecorded in accumulated other comprehensive income (loss) in partners’ equityand reclassified into earnings in the same period in which the hedgedtransaction closes. The asset or liability related to the derivativeinstruments is recorded on the balance sheet as fair value of derivative assetsor liabilities. Any ineffective portion of the gain or loss is recognized inearnings immediately.

 

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***Comprehensive Income (loss)***

 

Comprehensive income(loss) includes net income (loss) and other comprehensive income (loss), whichincludes, but is not limited to, changes in the fair value of derivativefinancial instruments. Pursuant to SFAS 133, for derivatives qualifying asaccounting hedges, the effective portion of changes in fair value arerecognized in partners’ equity as accumulated other comprehensive income (loss)and reclassified to earnings when the underlying hedged physical transactioncloses, to the extent of our interest in Hiland Partners. Our comprehensiveincome (loss) for the three and six months ended June 30, 2008 and 2007 ispresented in the table below:

 
| ** **                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income  (loss)                                     |       | $                                                   | 3,183      |                                              | $          | 1,139 |   | $ | 4,023 |   | $ | 1,887 |   |
| Closed  derivative transactions reclassified to income |       | 1,810                                               |       | (503                                              | )          | 3,043 |   | (835 | ) |
| Change in fair  value of derivatives                   |       | (4,605                                              | )          | 39                                                |       | (6,105 | ) | (793 | ) |
| Comprehensive  income (loss)                           |       | $                                                   | 388        |                                              | $          | 675 |   | $ | 961 |   | $ | 259 |   |

 

***Net Income (loss) per Limited Partners’Unit***

 

Net income (loss) perlimited partners’ unit is computed based on the weighted-average number ofcommon units outstanding during the period. The computation of diluted netincome (loss) per limited partner unit further assumes the dilutive effect ofrestricted units. Net income (loss) per limited partners’ unit is computed by dividingnet income (loss) applicable to limited partners by both the basic and dilutedweighted-average number of limited partnership units outstanding.

 

***Minority Interests***

 

The minority interest onour consolidated balance sheets as of June 30, 2008 and December 31,2007 reflects the outside ownership interest of Hiland Partners. Minorityinterest in income (loss) is calculated by multiplying the minority interestowners’ proportionate ownership of limited partner units in Hiland Partners bythe limited partners’ allocation of Hiland Partners’ net income (loss). HilandPartners’ net income (loss) is allocated to its limited partners and itsgeneral partner based on the proportionate share of the cash distributionsdeclared for the period, with adjustments made for incentive distributionsspecifically allocated to its general partner. All amounts we have receivedfrom Hiland Partners’ issuance and sale of limited partner units have beenrecorded as increases to the minority interest balance on the consolidatedbalance sheet.

 

***Contributions to Subsidiary***

 

The Partnership directlyand indirectly owns all of the equity interests in Hiland Partners GP, LLC, thegeneral partner of Hiland Partners. Hiland Partners GP, LLC is required to makecontributions to Hiland Partners each time Hiland Partners issues common unitsin order to maintain its 2% general partner ownership in Hiland Partners.Hiland Holdings was required to contribute $11 and $3 for the three monthsended June 30, 2008 and 2007, respectively, and was required to contribute$23 and $21 for the six months ended June 30, 2008 and 2007, respectively.

 

***Recent Accounting Pronouncements***

 

On March 19, 2008,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities”, an amendment of SFAS 133(“SFAS 161”). SFAS 161 is intended to improve transparency in financialreporting by requiring enhanced disclosures of an entity’s derivativeinstruments and hedging activities and their effects on the entity’s financialposition, financial performance, and cash flows. SFAS 161 is effectiveprospectively for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008, with early applicationencouraged. SFAS 161 encourages, but does not require, comparative disclosuresfor periods prior to its initial adoption. SFAS 161 amends the currentqualitative and quantitative disclosure requirements for derivative instrumentsand hedging activities set forth in SFAS 133 and generally increases the levelof aggregation/disaggregation that will be required in an entity’s financialstatements. We are currently reviewing SFAS 161 to determine the effect it willhave on our financial statements and disclosures therein.

 

On March 12, 2008,the Emerging Issues Task Force (“EITF”) reached consensus opinion on EITF Issue07-4, “Application of the two-class method under FASB Statement No. 128,Earnings per Share, to Master Limited Partnerships” 

 

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(“EITF 07-4”), which theFASB ratified at its March 26, 2008 meeting. EITF 07-4 requires thecalculation of a Master Limited Partnership’s (“MLPs”) net earnings per limitedpartner unit for each period presented according to distributions declared andparticipation rights in undistributed earnings as if all of the earnings forthat period had been distributed. In periods with undistributed earnings abovespecified levels, the calculation per the two-class method results in anincreased allocation of such undistributed earnings to the general partner anda dilution of earnings to the limited partners. EITF 07-4 is effective forfiscal years beginning after December 15, 2008, and is to be appliedretrospectively to all periods presented. Early application is not permitted.We will apply the requirements of EITF 07-4 as it pertains to MLPs upon itsadoption during the quarter ended March 31, 2009 and do not expect asignificant impact when adopted.

 

In December 2007,the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”).SFAS 141(R) amends and replaces SFAS 141, but retains the fundamentalrequirements in SFAS 141 that the purchase method of accounting be used for allbusiness combinations and an acquirer be identified for each businesscombination. SFAS 141(R) provides for how the acquirer recognizes andmeasures the identifiable assets acquired, liabilities assumed and anynon-controlling interest in the acquiree. SFAS 141(R) provides forhow the acquirer recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase. SFAS 141(R) also determineswhat information to disclose to enable users to be able to evaluate the natureand financial effects of the business combination. The provisions ofSFAS 141(R) apply prospectively to business combinations for whichthe acquisition date is on or after the beginning of the first annual reportingperiod beginning on or after December 15, 2008 and do not allow earlyadoption. We are evaluating the new requirements of SFAS 141(R) and theimpact it will have on business combinations completed in 2009 and thereafter.

 

 In December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interests in Consolidated Financial Statements — an amendmentof ARB No. 51” (“SFAS 160”). SFAS 160 establishes accounting and reportingstandards that require the ownership interests in subsidiaries held by partiesother than the parent (minority interest) be clearly identified, labeled andpresented in the consolidated balance sheet within equity, but separate fromthe parent’s equity. SFAS 160 requires the equity amount of consolidated netincome attributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated income statement andthat changes in a parent’s ownership interest while the parent retains itscontrolling financial interest in its subsidiary be accounted for consistentlyand similarly as equity transactions. Consolidated net income and comprehensiveincome will be determined without deducting minority interest; however,earnings-per-share information will continue to be calculated on the basis ofthe net income attributable to the parent’s shareholders. Additionally, SFAS160 establishes a single method for accounting for changes in a parent’sownership interest in a subsidiary that does not result in deconsolidation andthat the parent recognize a gain or loss in net income when a subsidiary isdeconsolidated. SFAS 160 is effective for fiscal years beginning on or after December 15,2008. Early adoption is not permitted. We do not expect SFAS 160 will have amaterial impact on our financial position, results of operations or cash flows.

 

 In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS159”). SFAS 159 expands opportunities to use fair value measurement infinancial reporting and permits entities to choose to measure many financialinstruments and certain other items at fair value. SFAS 159 is effective forfiscal years beginning after November 15, 2007. SFAS 159 was adopted by useffective January 1, 2008, at which time no financial assets orliabilities, not previously required to be recorded at fair value by otherauthoritative literature, were designated to be recorded at fair value. Assuch, the adoption of SFAS 159 did not have any impact on our financialposition, results of operations or cash flows.

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 defines fair value as the price thatwould be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date,establishes a framework for measuring fair value in generally acceptedaccounting principles (GAAP) such as fair value hierarchy used to classify thesource of information used in fair value measurements (i.e., market based ornon-market based) and expands disclosure about fair value measurements based ontheir level in the hierarchy.  SFAS 157applies to derivatives and other financial instruments, which SFAS 133 requiresbe measured at fair value at initial recognition and for all subsequentperiods. SFAS 157 establishes a fair value hierarchy which requires an entityto maximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value. SFAS 157’s hierarchy defines three levels ofinputs that may be used to measure fair value. Level 1 refers to assets thathave observable market prices, level 2 assets do not have an “observable price”but do have inputs that are based on such prices in which components haveobservable data points and level 3 refers to assets in which one or more of theinputs do not have observable prices and calibrated model parameters, valuationtechniques or management’s assumptions are used to derive the fair value. SFAS157 is effective for financial statements issued for fiscal years beginningafter November 15, 2007 and interim periods within those fiscal years. Weelected to implement SFAS 157 prospectively in the first quarter of 2008 withthe one-year deferral permitted by FASB Staff Position (FSP) 157-2 fornonfinancial assets and nonfinancial 

 

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liabilities measured atfair value, except those that are recognized or disclosed on a recurring basis(at least annually). The deferral applies to nonfinancial assets andliabilities measured at fair value in a business combination; impairedproperties, plants and equipment; intangible assets and goodwill; and initialrecognition of asset retirement obligations and restructuring costs for whichwe use fair value. We do not expect any significant impact to our consolidatedfinancial statements when we implement SFAS 157 for these assets andliabilities. See Note 5 “Fair Value Measurements of Financial Instruments.”

 

**Note 2: Propertyand Equipment and Asset Retirement Obligations**

 

Propertyand equipment consisted of the following for the periods indicated:

 
| ** **                                       | ** ** | **As of**    | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Land                                             |       | $                 | 298        |                  | $          | 295 |   |
| Construction in  progress                        |       | 7,395             |       | 12,030                |       |
| Midstream  pipeline, plants and compresors       |       | 378,982           |       | 356,491               |       |
| Compression and  water injection equipment       |       | 19,310            |       | 19,258                |       |
| Other                                            |       | 4,502             |       | 3,958                 |       |
|                                             |       | 410,487           |       | 392,032               |       |
| Less:  accumulated depreciation and amortization |       | 84,482            |       | 68,959                |       |
|                                             |       | $                 | 326,005    |                  | $          | 323,073 |   |

 

During the three and sixmonths ended June 30, 2008, we capitalized interest of $24 and $155,respectively. We capitalized $784 and $1,453 interest during the three and sixmonths ended June 30, 2007, respectively.

 

In accordance with SFAS No. 143,“Accounting for Asset Retirement Obligations” (“SFAS 143”), we have recordedthe fair value of liabilities for asset retirement obligations in the periodsin which they are incurred and corresponding increases in the carrying amountsof the related long-lived assets. The asset retirement costs are subsequentlyallocated to expense using a systematic and rational method and the liabilitiesare accreted to measure the change in liability due to the passage of time. Theprovisions of SFAS 143 primarily apply to dismantlement and site restoration ofcertain of our plants and pipelines. We have evaluated our asset retirementobligations as of June 30, 2008 and have determined that revisions in thecarrying values are not necessary at this time.

 

The following tablesummarizes our activity related to asset retirement obligations for theindicated period:

 
| Asset retirement  obligation, January 1, 2008 |   | $  | 2,159  |   |
|----------------------------------------------------|--------|----|--------|--------|
| Add: additions  on leased locations                |   | 97 |   |
| Add: accretion  expense                            |   | 66 |   |
| Asset retirement  obligation, June 30, 2008   |   | $  | 2,322  |   |

 

**Note 3:   Intangible Assets**

 

Intangible assets consistof the acquired value of customer relationships, existing contracts to sellnatural gas and other NGLs and compression contracts, which do not havesignificant residual value. The customer relationships and the contracts arebeing amortized over their estimated lives of ten years. We review intangibleassets for impairment whenever events or circumstances indicate that thecarrying amounts may not be recoverable. If such a review should indicate thatthe carrying amount of intangible assets is not recoverable, we reduce thecarrying amount of such assets to fair value based on the discounted probablecash flows of the intangible assets. No impairments of intangible assets wererecorded during the three and six months ended June 30, 2008 or 2007.

 

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Intangible assetsconsisted of the following for the periods indicated:

 
| ** **                     | ** ** | **As of**    | ** ** | **As of**        | ** ** |
|--------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Gas sales  contracts           |       | $                 | 32,564     |                  | $          | 32,564 |   |
| Compression  contracts         |       | 18,515            |       | 18,515                |       |
| Customer relationships         |       | 10,492            |       | 10,492                |       |
|                           |       | 61,571            |       | 61,571                |       |
| Less accumulated  amortization |       | 17,712            |       | 14,634                |       |
| Intangible  assets, net        |       | $                 | 43,859     |                  | $          | 46,937 |   |

 

During each of the threemonths ended June 30, 2008 and 2007, we recorded $1,540 of amortizationexpense.  During each of the six monthsended June 30, 2008 and 2007, we recorded $3,078 of amortizationexpense.  Estimated aggregateamortization expense for the remainder of 2008 is $3,079 and $6,157 for each ofthe four succeeding fiscal years from 2009 through 2012 and a total of $16,152for all years thereafter.

 

**Note 4: Derivatives**

 

Hiland Partners hasentered into certain derivative contracts that are classified as cash flowhedges in accordance with SFAS 133 and relate to forecasted sales in 2008,2009, and a non-qualifying mark-to-market cash flow hedge that relates toforecasted sales in 2010. Hiland Partners entered into these financial swapinstruments to hedge forecasted natural gas and natural gas liquids (NGLs)sales or purchases against the variability in expected future cash flowsattributable to changes in commodity prices. Under these contractual swapagreements with Hiland Partners’ counterparty, Hiland Partners receives a fixedprice and pays a floating price or Hiland Partners pays a fixed price andreceives a floating price based on certain indices for the relevant contractperiod as the underlying natural gas is sold or purchased or NGL is sold.

 

Hiland Partners formallydocuments all relationships between hedging instruments and the items being hedged,including its risk management objective and strategy for undertaking thehedging transactions. This includes matching the natural gas and NGL futures,the “sold fixed for floating price” or “buy fixed for floating price”contracts, to the forecasted transactions. Hiland Partners assesses, both atthe inception of the hedge and on an ongoing basis, whether the derivatives arehighly effective in offsetting changes in the fair value of hedged items.Highly effective is deemed to be a correlation range from 80% to 125% of thechange in cash flows of the derivative in offsetting the cash flows of thehedged 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 NGL reference pricesunder a hedging instrument and actual natural gas or NGL prices, HilandPartners will discontinue hedge accounting for the derivative and subsequentchanges in fair value for the derivative will be recognized immediately intoearnings. Hiland Partners assesses effectiveness using regression analysis andineffectiveness using the dollar offset method.

 

Derivatives are recordedon our consolidated balance sheet as assets or liabilities at fair value. Forderivatives qualifying as hedges, the effective portion of changes in fairvalue are recognized in partners’ equity as accumulated other comprehensiveloss and reclassified to earnings when the underlying hedged physicaltransaction closes. Changes in fair value of non-qualifying derivatives and theineffective portion of qualifying derivatives are recognized in earnings asthey occur. Actual amounts that will be reclassified will vary as a result offuture changes in prices. Hedge ineffectiveness is recorded in income (loss)while the hedge contract is open and may increase or decrease until settlementof the contract. Realized cash gains and losses on closed/settled instrumentsand hedge ineffectiveness are reflected in the contract month being hedged asan adjustment to our midstream revenue.

 

On May 27, 2008Hiland Partners entered into a financial swap instrument related to forecastednatural gas sales in 2010 whereby Hiland Partners receives a fixed price andpays a floating price based on NYMEX Henry Hub pricing for the relevantcontract period as the underlying natural gas is sold. This financial swapinstrument does not qualify for hedge accounting as there is inadequatecorrelation between NYMEX Henry Hub natural gas prices and actual pricesreceived for the natural gas sold. It is Hiland Partners’ management’s intentto swap a fixed and pay a floating Colorado Interstate Gas (“CIG”) basisdifferential to the contract NYMEX price in a future period.  Until, and if, this hedge positionqualifies for hedge accounting treatment, increases or decreases in the fairvalue of the derivative will be recorded directly to midstream revenues asgains or losses.

 

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Presented in the tablebelow is information related to Hiland Partners’ derivatives for the indicatedperiods:

 
| ** **                                                                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                  | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                                                                  | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net gains  (losses) on closed/settled transactions reclassified from (to) accumulated  other comprehensive income (loss)    |       | $                                | (1,810     | )                              | $          | 503 |   | $ | (3,043 | ) | $ | 835 |   |
| Increases  (decreases) in fair values of open derivatives recorded to (from) accumulated  other comprehensive income (loss) |       | $                                | (4,605     | )                              | $          | 39 |   | $ | (6,105 | ) | $ | (793 | ) |
| Unrealized  non-cash gains (losses) on ineffective portions of qualifying derivative  transactions                          |       | $                                | (13        | )                              | $          | 2 |   | $ | (3 | ) | $ | (6 | ) |
| Unrealized  non-cash gains (losses) on non-qualifying derivatives                                                           |       | $                                | (900       | )                              | $          | 59 |   | $ | (1,139 | ) | $ | 107 |   |

 

At June 30, 2008,our accumulated other comprehensive loss related to qualifying derivatives was$(6,487). Of this amount, we anticipate $6,170 will be reclassified from earningsduring the next twelve months and $317 will be reclassified from earnings insubsequent periods.

 

Thefair value of derivative assets and liabilities are as follows for theindicated periods:

 
| ** **                                        | ** ** | **As of**    | ** ** | **As of**        | ** ** |
|---------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                        | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Fair value of  derivative assets - current        |       | $                 | 1,483      |                  | $          | 2,718 |   |
| Fair value of  derivative assets - long term      |       | —            |       | 418                   |       |
| Fair value of  derivative liabilities - current   |       | (11,785           | )          | (8,238                | )          |
| Fair value of  derivative liabilities - long term |       | (2,045            | )          | (141                  | )          |
| Net fair value  of derivatives                    |       | $                 | (12,347    | )                     | $          | (5,243 | ) |

 

The terms of HilandPartners’ derivative contracts currently extend out as far as December 2010.Hiland Partners’ counterparties to its derivative contracts are BP EnergyCompany and Bank of Oklahoma, N.A. Set forth below is the summarized notionalamount and terms of all instruments held for price risk management purposes at June 30,2008.

 
| ** **                                           | ** ** | ** **  | ** ** | **Average**          | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------|------------|-------------|------------|----------------------|------------|---------------------|------------|
| ** **                                           | ** ** | ** **  | ** ** | **Fixed**            | ** ** | **Asset**           | ** ** |
| **Description and Production Period** | ** ** | **Volume**  | ** ** | **Price**            | ** ** | **(Liability)**     | ** ** |
| ** **                                           | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **          | ** ** |
| Natural Gas -  Sold Fixed for Floating Price Swaps   |       |        |       |                 |       |                |       |
| July 2008 -  June 2009                     |       | 2,058,000   |       | $                    | 7.56       |                | $          | (4,188 | ) |
| July 2009 -  December 2009                 |       | 1,068,000   |       | $                    | 7.30       |                | (533       | ) |
| January 2010  - December 2010              |       | 2,136,000   |       | $                    | 10.50      |                | (1,512     | ) |
|                                                 |       |        |       |                 |       | $                   | (6,233     | ) |

 
| ** **                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-------------|------------|----------------------|------------|------------|------------|
| Natural Gas -  Buy Fixed for Floating Price Swaps |       |        |       |                 |       |       |       |
| July 2008 -  December 2008              |       | 360,576     |       | $                    | 6.93       |       | $          | 1,483 |   |
|                                                   |            |             |            |                      |            |            |            |  |  |

 
| ** **                                                 | ** ** | **(Bbls)** | ** ** | **(per Gallon)** | ** ** | ** ** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-----------------------|------------|------------|------------|
| Natural Gas  Liquids - Sold Fixed for Floating Price Swaps |       |       |       |                  |       |       |       |
| July 2008 -  December 2008                       |       | 220,884    |       | $                     | 1.31       |       | $          | (7,597 | ) |
|                                                            |            |            |            |                       |            |            |            |  |  |

 

**Note 5:  ****Fair ValueMeasurements of Financial Instruments**

 

We adopted SFAS No. 157,“Fair Value Measurements” (“SFAS 157”) beginning in the first quarter of 2008.SFAS 157 defines fair value as the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date, establishes a framework for measuringfair value in GAAP such as fair value hierarchy used to classify the source ofinformation used in fair value measurements (i.e., market based or non-market 

 

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based) and expands disclosure about fair value measurements based ontheir level in the hierarchy.  SFAS 157applies to derivatives and other financial instruments, which SFAS 133 requiresbe measured at fair value at initial recognition and for all subsequentperiods. SFAS 157 establishes a fair value hierarchy which requires an entityto maximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value. SFAS 157’s hierarchy defines three levels ofinputs that may be used to measure fair value. Level 1 refers to assets thathave observable market prices, level 2 assets do not have an “observable price”but do have inputs that are based on such prices in which components haveobservable data points and level 3 refers to assets in which one or more of theinputs do not have observable prices and calibrated model parameters, valuationtechniques or management’s assumptions are used to derive the fair value.

 

We use the fair valuemethodology outlined in SFAS 157 to value assets and liabilities for ouroutstanding fixed price cash flow swap derivative contracts. Valuations of ournatural gas and propane derivative contracts are based on published forwardprice curves for natural gas and propane and, as such, are defined as Level 2 fairvalue hierarchy assets and liabilities. There are no published forward pricecurves for butanes or natural gasoline, and therefore, our butanes and naturalgasoline derivative contracts are defined as Level 3 fair value hierarchyassets and liabilities. We value our butanes and natural gasoline derivativecontracts based on calibrated model parameters relative to forward publishedprice curves for crude oil and comparative mark-to-market values received fromour counterparty.  The following tablerepresents the fair value hierarchy for Hiland Partners’ assets and liabilitiesat June 30, 2008:

 
| ** **                               | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Commodity -based  derivative assets      |       | $                | —     |             | $          | 1,483            |       | $         | —     |   | $ | 1,483 |   |
| Commodity -based  derivative liabilities |       | —           |       | (9,295           | )          | (4,535           | )          | (13,830   | )          |
| Total                                    |       | $                | —     |             | $          | (7,812           | )          | $         | (4,535     | ) | $ | (12,347 | ) |

 

Thefollowing table provides a summary of changes in the fair value of HilandPartners’ Level 3 commodity-based derivatives for the six months ended June 30,2008:

 
| ** **                                               | ** ** | **Fixed Price** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **Cash Flow**   | ** ** |
| ** **                                               | ** ** | **Swaps**            | ** ** |
| Balance  January 1, 2008                            |       | $                    | (4,489     | ) |
| Cash settlements  from other comprehensive income (loss) |       | 3,353                |       |
| Net change in  other comprehensive income (loss)         |       | (3,399               | )          |
| Balance  June 30, 2008                              |       | $                    | (4,535     | ) |

 

**Note 6: Long-TermDebt**

 
| ** **                                         | ** ** | **As of**    | ** ** | **As of**        | ** ** |
|----------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                         | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Hiland Partners  Credit Facility                   |       | $                 | 240,064    |                  | $          | 221,064 |   |
| Hiland Holdings  Credit Facility                   |       | 355               |       | 355                   |       |
| Capital lease  obligations                         |       | 5,350             |       | 5,585                 |       |
|                                               |       | 245,769           |       | 227,004               |       |
| Less current  portion of capital lease obligations |       | 619               |       | 545                   |       |
| Long-term debt                                     |       | $                 | 245,150    |                  | $          | 226,459 |   |

 

***Hiland Partners Credit Facility***

 

On February 6, 2008,Hiland Partners entered into a fourth amendment to its credit facility dated February 15,2005. Pursuant to the fourth amendment, Hiland Partners has, among otherthings, increased its borrowing base from $250 million to $300 million anddecreased the accordion feature in the facility from $100 million to $50million.  Hiland Partners’ originalcredit facility dated February 15, 2005 was first amended in September 2005,amended a second time in June 2006 and amended a third time in July 2007.

 

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The fourth amendmentincreases Hiland Partners’ borrowing capacity under its senior securedrevolving credit facility to $300 million such that the facility now consistsof a $291 million senior secured revolving credit facility to be used forfunding acquisitions and other capital expenditures, issuance of letters ofcredit and general corporate purposes (the “Acquisition Facility”) and a $9.0million senior secured revolving credit facility to be used for working capitaland to fund distributions (the “Working Capital Facility”).

 

In addition, the fourthamendment provides for an accordion feature, which permits Hiland Partners, ifcertain conditions are met, to increase the size of the Acquisition Facility byup to $50 million and allows for the issuance of letters of credit of upto $15 million in the aggregate. The senior secured revolving creditfacility also requires HIiland Partners to meet certain financial tests,including a maximum consolidated funded debt to EBITDA ratio of 4.0:1.0 as ofthe last day of any fiscal quarter; provided that in the event that HilandPartners makes certain permitted acquisitions or capital expenditures, thisratio may be increased to 4.75:1.0 for the three fiscal quarters following thequarter in which such acquisition or capital expenditure occurs; and a minimuminterest coverage ratio of 3.0:1.0.  Thecredit facility will mature in May 2011. At that time, the agreement willterminate and all outstanding amounts thereunder will be due and payable.

 

Hiland Partners’obligations under the credit facility are secured by substantially all of itsassets and guaranteed by Hiland Partners, and all of its subsidiaries, otherthan Hiland Operating, LLC, its operating company, which is the borrower underthe credit facility.

 

Indebtedness under thecredit facility will bear interest, at Hiland Partners’ option, at either (i) anAlternate Base Rate plus an applicable margin ranging from 50 to 125 basispoints per annum or (ii) LIBOR plus an applicable margin ranging from 150to 225 basis points per annum based on its ratio of consolidated funded debt toEBITDA. The Alternate Base Rate is a rate per annum equal to the greatest of (a) thePrime Rate in effect on such day, (b) the base CD rate in effect on suchday plus 1.50% and (c) the Federal Funds effective rate in effect on suchday plus 1⁄2 of 1%. A letter of credit fee will be payable for the aggregateamount of letters of credit issued under the credit facility at a percentageper annum equal to 1.0%. An unused commitment fee ranging from 25 to 50 basispoints per annum based on Hiland Partners’ ratio of consolidated funded debt toEBITDA will be payable on the unused portion of the credit facility. During anystep-up period, the applicable margin with respect to loans under the creditfacility will be increased by 35 basis points per annum and the unusedcommitment fee will be increased by 12.5 basis points per annum. At June 30,2008, the interest rate on outstanding borrowings from Hiland Partners’ creditfacility was 4.78%.

 

The credit facilityprohibits Hiland Partners from making distributions to unitholders if anydefault or event of default, as defined in the credit facility, has occurredand is continuing or would result from the distribution. In addition, thecredit facility contains various covenants that limit, among other things,subject to certain exceptions and negotiated “baskets,” Hiland Partners’ability to incur indebtedness, grant liens, make certain loans, acquisitionsand investments, make any material changes to the nature of its business, amendits material agreements, including its Omnibus Agreement, or enter into amerger, consolidation or sale of assets.

 

The credit facilitydefines EBITDA as Hiland Partners’ consolidated net income (loss), plus incometax expense, interest expense, depreciation, amortization and accretionexpense, amortization of intangibles and organizational costs, non-cash unitbased compensation expense, and adjustments for non-cash gains and losses onspecified derivative transactions and for other extraordinary or non-recurringitems.

 

Upon the occurrence of anevent of default as defined in the credit facility, the lenders may, amongother things, be able to accelerate the maturity of the credit facility andexercise other rights and remedies as set forth in the credit facility.

 

The credit facilitylimits distributions to Hiland Partners’ unitholders to available cash, asdefined by the agreement, and borrowings to fund such distributions are onlypermitted under the revolving working capital facility. The revolving workingcapital facility is subject to an annual “clean-down” period of 15 consecutivedays in which the amount outstanding under the revolving working capitalfacility is reduced to zero.

 

As of June 30, 2008,Hiland Partners had $240.1 million outstanding under this credit facilityand was in compliance with all of the financial covenants contained in thecredit facility.

 

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***Hiland Holdings Credit Facility***

 

On September 25,2006, concurrently with the closing of our initial public offering, we enteredinto a three-year $25.0 million secured revolving credit facility. Thecredit facility will permit us, if certain conditions are met, to increaseborrowing capacity by up to an additional $25.0 million. The credit facility issecured by all of our ownership interests in Hiland Partners and its generalpartner, other than the 2% general partner interest and the incentivedistribution rights.

 

The credit facility willmature on September 25, 2009, at which time all outstanding amountsthereunder become due and payable.

 

Indebtedness under thecredit facility bears interest, at our option, at either (i) an alternatebase rate plus an applicable margin ranging from 100 to 150 basis points perannum or (ii) LIBOR plus an applicable margin ranging from 200 to 250basis points per annum in each case based on our ratio of consolidated fundeddebt to EBITDA. The alternate base rate is equal to the greatest of (a) theprime rate in effect on such day, (b) the base CD rate in effect on suchday plus 1.50% and (c) the federal funds effective rate in effect on suchday plus  1/2  of 1%. A letter of credit fee will be payablefor the aggregate amount of letters of credit issued under the credit facilityat a percentage per annum equal to 2.0%. A commitment fee ranging from 25 to 50basis points per annum based on our ratio of consolidated funded debt to EBITDAwill be payable on the average daily unused portion of the credit facility forthe quarter most recently ended. At June 30, 2008, the interest rate onoutstanding borrowings from our credit facility was 4.48%.

 

The credit facilitycontains several covenants that, among other things, require the maintenance oftwo financial performance ratios, restrict the payment of distributions tounitholders, and require financial reports to be submitted periodically to thefinancial institutions.

 

The credit facility alsocontains covenants requiring a maximum consolidated funded debt to EBITDA ratioof 3.0:1.0 for the four fiscal quarters most recently ended and a minimuminterest coverage ratio of 3.0:1.0.

 

The amount we may borrowunder the credit facility is limited to the lesser of: (i) 50% of the sumof the value of the Hiland Partners common and subordinated units and certainother assets held by us and certain of our subsidiaries at the end of eachfiscal quarter and (ii) the maximum available amount of the creditfacility (currently $25.0 million).

 

The credit facilityprohibits us from making distributions to unitholders if any default or eventof default, as defined in the credit facility, has occurred and is continuingor would result from the distribution. In addition, the credit facilitycontains various covenants that limit, among other things, subject to certainexceptions and negotiated “baskets,” our ability to incur indebtedness, grantliens, enter into agreements restricting our ability to grant liens on ourassets or amend the credit facility, make certain loans, acquisitions andinvestments or enter into a merger, consolidation or sale of assets.

 

The credit facilitylimits distributions to our unitholders to our available cash, as defined inour partnership agreement. Restricted payments under the credit facility aresubject to an annual “clean-down” period of 15 consecutive days in which theamount outstanding that relates to funding the restricted payments under thecredit facility must be reduced to zero.

 

As of June 30, 2008,we had $0.4 million outstanding under this credit facility and were incompliance with our financial covenants.

 

***Capital Lease Obligations***

 

During the third quarterof 2007, Hiland Partners incurred two separate capital lease obligations at theBakken and Badlands gathering systems. Under the terms of a capital leaseagreement for a rail loading facility and an associated products pipeline atthe Bakken gathering system, Hiland Partners has agreed to repay a counterpartya predetermined amount over a period of eight years. Once fully paid, title tothe leased assets will transfer to Hiland Partners no later than the end of theeight-year period commencing from the inception date of the lease. HilandPartners also incurred a capital lease obligation to a counterparty for the aidto construct several electric substations at Hiland Partners’ Badlandsgathering system which, by agreement, will be repaid in equal monthlyinstallments over a period of five years.

 

During the three and sixmonths ended June 30, 2008, Hiland Partners made principal payments of$128 and $235, respectively, on the above described capital leaseobligations.  The current portion of thecapital lease obligations presented in the table above is included in accruedliabilities and other in the balance sheet.

 

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**Note 7:  Share-Based Compensation**

 

***Hiland Holdings GP, LP Long Term IncentivePlan***

 

Hiland Partners GPHoldings, LLC, the general partner of Hiland Holdings, adopted the HilandHoldings GP, LP Long-Term Incentive Plan for its employees and directors of itsgeneral partner and employees of its affiliates. The long-term incentive planconsists of three components: unit options, restricted units and phantom units.The long-term incentive plan limits the number of units that are permitted tobe delivered pursuant to awards to 2,160,000 units. The plan is administered bythe board of directors of our general partner or the compensation committee ofthe board of directors of our general partner. The plan will expire upon thefirst to occur of its termination by the board of directors or the compensationcommittee, the date when no units remain available under the plan for awards orthe tenth anniversary of the date the plan is approved by our unitholders.Awards then outstanding will continue pursuant to the terms of their grants.

 

The board of directors ofour general partner and the compensation committee of the board may terminateor amend the long-term incentive plan at any time with respect to any units forwhich a grant has not yet been made. Our board of directors and thecompensation committee of the board also have the right to alter or amend thelong-term incentive plan or any part of the plan from time to time, includingincreasing the number of units that may be granted subject to unitholderapproval as may be required by applicable law or stock exchange rules. However,no change in any outstanding grant may be made that would materially reduce thebenefits of the participant without the consent of the participant. Restrictedcommon units granted vest and become exercisable in one-fourth increments onthe anniversary of the grant date over four years. A restricted unit is acommon unit that is subject to forfeiture, and upon vesting, the granteereceives a common unit that is not subject to forfeiture. Distributions onunvested restricted common units are held in trust by our general partner untilthe units vest, at which time the distributions are distributed to the grantee.

 

As provided for in thelong-term incentive plan, each non-employee board member of Hiland Partners GPHoldings, LLC on each anniversary date of the initial award is entitled toreceive an additional 1,000 restricted common units. We issued no restrictedunits during the three and six months ended June 30, 2008. As of June 30,2008 and December 31, 2007, we had 15,000 restricted common unitsoutstanding with a weighted average fair value at grant date of $23.30 perrestricted unit. Non-cash unit based compensation expense related to the 15,000restricted units issued is to be recognized over their respective four-yearvesting period on the graded vesting attribution method. We recorded non-cashcompensation expense related to the restricted units of $38 and $77 for thethree and six months ended June 30, 2008, respectively, and $32 and $63for the three and six months ended June 30, 2007, respectively. We willrecord additional non-cash unit based compensation expense of $168 over thenext four years.

 

***Hiland Partners, LP Long Term IncentivePlan***

 

Hiland Partners GP, LLC,the general partner of Hiland Partners, adopted the Hiland Partners, LPLong-Term Incentive Plan for its employees and directors of its general partnerand employees of its affiliates. The long-term incentive plan currently permitsan aggregate of 680,000 of Hiland Partners common units to be issued withrespect to unit options, restricted units and phantom units granted under theplan. No more than 225,000 of the 680,000 common units may be issued withrespect to vested restricted or phantom units. The plan is administered by thecompensation committee of Hiland Partners GP, LLC’s board ofdirectors. The plan will continue in effect until the earliest of (i) adate determined by the board of directors of the general partner; (ii) thedate that common units are no longer available for payment of awards under theplan; or (iii) the tenth anniversary of the plan.

 

Hiland Partners GP, LLC’sboard of directors or compensation committee may, in their discretion,terminate, suspend or discontinue the long-term incentive plan at any time withrespect to any units for which a grant has not yet been made. Hiland PartnersGP, LLC’s board of directors or its compensation committee also has the rightto alter or amend the long-term incentive plan or any part of the plan fromtime to time, including increasing the number of units that may be granted,subject to unitholder approval if required by the exchange upon which thecommon units are listed at that time. No change in any outstanding grant may bemade, however, that would materially impair the rights of the participantwithout the consent of the participant. Under the unit option grant agreement,granted options of common units vest and become exercisable in one-thirdincrements on the anniversary of the grant date over three years. Vested optionsare exercisable within the option’s contractual life of ten years after thegrant date. Restricted common units granted vest and become exercisable inone-fourth increments on the anniversary of the grant date over four years. Arestricted unit is a common unit that is subject to forfeiture, and uponvesting, the grantee receives a common unit that is not subject to forfeiture.Distributions on unvested restricted 

 

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common units are held intrust by Hiland Partners’ general partner until the units vest, at which timethe distributions are distributed to the grantee. Granted phantom common unitsare generally more flexible than restricted units and vesting periods anddistribution rights may vary with each grant. A phantom unit is a common unitthat is subject to forfeiture and is not considered issued until it vests. Uponvesting, holders of phantom units will receive (i) a common unit that isnot subject to forfeiture, cash in lieu of the delivery of such unit equal tothe fair market value of the unit on the vesting date, or a combinationthereof, at the discretion of our general partner’s board of directors and (ii) thedistributions held in trust, if applicable, related to the vested units.

 

*PhantomUnits. * On June 19, 2008, 2,500 of HilandPartners’ phantom units awarded to its Chief Executive Officer in June 2007vested and were converted to common units. On the same date, Hiland Partners redeemed 693 of the vested phantomunits for $50.00 per unit, the closing price on that day to pay for taxwithholding obligations on the vested phantom units.

 

Thefollowing table summarizes information about Hiland Partners’ phantom units forthe six months ended June 30, 2008:

 
| ** **                     | ** ** | ** ** | ** ** | **Weighted**        | ** ** | ** **                  | ** ** |
|--------------------------------|------------|------------|------------|---------------------|------------|-----------------------------|------------|
| ** **                     | ** ** | ** ** | ** ** | **Average**         | ** ** | ** **                  | ** ** |
| ** **                     | ** ** | ** ** | ** ** | **Fair Value** | ** ** | **Fair Value At** | ** ** |
| ** **                     | ** ** | ** ** | ** ** | **At Grant**   | ** ** | **Redemption**              | ** ** |
| ** **                     | ** ** | **Units**  | ** ** | **Date**            | ** ** | **Date**                    | ** ** |
| Unvested  January 1, 2008 |       | 42,825     |       | $                   | 50.12      |                        |       |   |
| Granted                        |       | 10,000     |       | $                   | 49.36      |                        |       |   |
| Vested and  converted          |       | (1,807     | )          | $                   | 54.50      |                        |       |   |
| Vested and  redeemed           |       | (693       | )          | $                   | 54.50      |                        | $          | 50.00 |   |
| Forfeited                      |       | (5,000     | )          | $                   | 48.80      |                        |       |   |
| Unvested  June 30, 2008   |       | 45,325     |       | $                   | 49.85      |                        |       |   |
|                                |            |            |            |                     |            |                             |            |  |  |

 

During the threeand six months ended June 30, 2008, Hiland Partners incurred non-cash unitbased compensation expense of $301 and $580, respectively, related to phantomunits. During the three and six months ended June 30 2007, Hiland Partnersincurred $9 of non-cash unit based compensation expense related to phantomunits. Hiland Partners will recognize additional expense of $1,580 over thenext four years, and the additional expense is to be recognized over a weightedaverage period of 3.2 years.

 

*RestrictedUnits.*   HilandPartners issued no restricted units during the three and six months ended June 30,2008.  As of June 30, 2008 and December 31, 2007, HilandPartners had 19,375 restricted common units outstanding with a weighted averagefair value at grant date of $46.57 per restricted unit outstanding. Non-cashunit based compensation expense related to restricted units was $83 and $167for the three and six months ended June 30, 2008, respectively, and was$120 and $239 for the three and six months ended June 30, 2007,respectively. As of June 30, 2008, there was $391 of total unrecognizedcost related to unvested restricted units. This cost is to be recognized over aweighted average period of 2.3 years.

 

*UnitOptions.*   HilandPartners has not granted unit options since March 2006. In October 1995,The FASB issued SFAS No. 123, “Share-Based Payment,” which was revised in December 2004(collectively, “SFAS 123R”). As a result of adopting SFAS 123R on the modifiedprospective basis beginning on January 1, 2006, during the three and sixmonths ended June 30, 2008, Hiland Partners incurred non-cash unit basedcompensation expense of $8 and $16, respectively, related to unit options thatwere awarded in both 2006 and 2005. During the three and six months ended June 30,2007, Hiland Partners expensed $39 and $97, respectively, related to the unitoptions.

 

The followingtable summarizes information about Hiland Partners’ common unit options for thethree and six months ended June 30, 2008:

 
| ** **                           | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted-**         | ** ** | ** **    | ** ** |
|--------------------------------------|------------|------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                           | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                           | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| **Options**                          | ** ** | **Units**  | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
| Outstanding at  January 1, 2008 |       | 75,041     |       | $            | 28.24      |                  |       |          |       |   |
| Granted                              |       | —     |       |         |       |                  |       |          |       |
| Exercised                            |       | (40,705    | )          | $            | 25.32      |                  |       |          | $          | 975 |   |
| Forfeited or  expired                |       | (1,000     | )          | $            | 40.11      |                  |       |          |       |   |
| Outstanding at June 30,  2008   |       | 33,336     |       | $            | 37.92      |                  | 7.5        |          | $          | 395 |   |
| Exercisable at  June 30, 2008   |       | 17,168     |       | $            | 37.21      |                  | 7.4        |          | $          | 216 |   |

 

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**Note 8: Commitments and Contingencies**

 

Hiland Partners hasexecuted a natural gas fixed price physical forward sales contract on 100,000MMBtu per month for the remainder of 2008 with a fixed price of $8.43 perMMBtu.  This contract has been designatedas a normal sale under SFAS 133 and is therefore not marked to market as aderivative.

 

We maintain a definedcontribution retirement plan for our employees under which we makediscretionary contributions to the plan based on a percentage of eligible employees’compensation. Contributions to the plan are 5.0% of eligible employees’compensation and resulted in expense for the three months ended June 30,2008 and 2007 of $80 and $64, respectively, and for the six months ended June 30,2008 and 2007 was $155 and $126, respectively.

 

We maintain our healthand workers’ compensation insurance through third-party providers. Property andgeneral liability insurance is also maintained through third-party providerswith a $100 deductible on each policy.

 

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

 

Although there are nosignificant regulatory proceedings in which we are currently involved,periodically we may be a party to regulatory proceedings. The results ofregulatory proceedings cannot be predicted with certainty; however, ourmanagement believes that we presently do not have material potential liabilityin connection with regulatory proceedings that would have a significantfinancial impact on our consolidated financial condition, results of operationsor cash flows.

 

Hiland Partners leasescertain equipment, vehicles and facilities under operating leases, most ofwhich contain annual renewal options. We and Hiland Partners also lease officespace from a related entity. See Note 10 “Related Party Transactions.” Underthese lease agreements, rent expense was $636 and $495, respectively, for thethree months ended June 30, 2008 and 2007 and $1,252 and $1,009 for thesix months ended June 30, 2008 and 2007, respectively.

 

**Note 9: Significant Customers and Suppliers**

 

All of Hiland Partners’revenues are domestic revenues. The following table presents Hiland Partners’top midstream customers as a percent of total revenue for the periodsindicated:

 
| ** **      | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|-----------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **      | ** ** | **2008**                                                          | ** ** | **2007**                                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Customer 1 |       | 22                                                                | %          | 15                                                              | %          | 21 | % | 16 | % |
| Customer 2      |       | 15                                                                | %          | 14                                                              | %          | 15 | % | 11 | % |
| Customer 3      |       | 14                                                                | %          | 7                                                               | %          | 11 | % | 9 | % |
| Customer 4      |       | 10                                                                | %          | 10                                                              | %          | 8 | % | 11 | % |
| Customer 5      |       | 9                                                                 | %          | 25                                                              | %          | 14 | % | 21 | % |

 

Collections of tradeaccounts receivable totaling $8,103 related to midstream sales to customer 1for the three and six months ended June 30, 2008 are doubtful, andaccordingly, Hiland Partners has increased its reserve for doubtful accountsand recorded a bad debt expense for the indicated periods. See Note 14 “SubsequentEvent.”

 

All of Hiland Partners’purchases are from domestic sources. The following table presents HilandPartners’ top midstream suppliers as a percent of total midstream purchases forthe periods indicated:

 
| ** **                                     | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2008**                                                          | ** ** | **2007**                                                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Supplier 1 (affiliated company) |       | 42                                                                | %          | 27                                                              | %          | 40 | % | 27 | % |
| Supplier 2                                     |       | 18                                                                | %          | 26                                                              | %          | 18 | % | 26 | % |
| Supplier 3                                     |       | 16                                                                | %          | 13                                                              | %          | 16 | % | 14 | % |

 

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**Note 10: Related Party Transactions**

 

Hiland Partners purchasesnatural gas and NGLs from affiliated companies. Purchases of product fromaffiliates totaled $36,882 and $13,008 for the three months ended June 30,2008 and 2007, respectively and totaled $63,049 and $24,742 for the six monthsended June 30, 2008 and 2007, respectively. Hiland Partners also sellsnatural gas and NGLs to affiliated companies. Sales of product to affiliatestotaled $2,022 and $747 for the three months ended June 30, 2008 and 2007,respectively and totaled $3,043 and $1,736 for the six months ended June 30,2008 and 2007, respectively. Compression revenues from affiliates were $1,205and $2,410 for each of the three and six months ended June 30, 2008 and2007, respectively.

 

Accountsreceivable-affiliates of $2,951 at June 30, 2008 include $2,850 from oneaffiliate for midstream sales. Accounts receivable-affiliates of $1,178 at December 31,2007, includes $1,090 from one affiliate for midstream sales.

 

Accountspayable-affiliates of $15,411 at June 30, 2008 include $14,641 due to oneaffiliate for midstream purchases. Accounts payable-affiliates of $7,957 at December 31,2007 include $7,094 payable to the same affiliate for midstream purchases

 

Hiland Partners utilizesaffiliated companies to provide services to its plants and pipelines andcertain administrative services. The total expenditures to these companies were$111 and $180 during the three months ended June 30, 2008 and 2007,respectively, and were $263 and $274 during the six months ended June 30,2008 and 2007, respectively.

 

We and Hiland Partnerslease office space under operating leases directly or indirectly from anaffiliate. Rent expense associated with these leases totaled $37 and $70 forthe three months ended June 30, 2008 and 2007, respectively, and totaled$75 and $102 for the six months ended June 30, 2008 and 2007,respectively.

 

**Note 11: Reportable Segments**

 

Hiland Partners hasdistinct operating segments for which additional financial information must bereported. Hiland Partners’ operations are classified into two reportablesegments:

 

(1)  Midstream, which is the purchasing, gathering, compressing, dehydrating,treating, processing and marketing of natural gas and fractionating andmarketing of NGLs.

 

(2)  Compression, which is providing air compression and water injection servicesfor oil and gas secondary recovery operations that are ongoing in North Dakota.

 

These business segmentsreflect the way Hiland Partners manages its operations. Hiland Partners’operations are conducted in the United States. General and administrativecosts, which consist of executive management, accounting and finance,operations and engineering, marketing and business development, are allocatedto the individual segments based on revenues.

 

Midstream assets totaled$412,377 at June 30, 2008. Assets attributable to compression operationstotaled $26,079. All but $24 of the total capital expenditures of $18,368 forthe six months ended June 30, 2008 was attributable to midstreamoperations. All but $16 of the total capital expenditures of $43,294 for thesix months ended June 30, 2007 was attributable to midstream operations.

 

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The tables below presentinformation for the reportable segments for the three and six months ended June 30,2008 and 2007.

 
| ** **                                                       | ** ** | **For the Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2008**                                                              | ** ** | **2007** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                         | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Segment**                                                           | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
| ** **                                                       | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                         |       | $                                                                     | 114,236    |   | $ | 1,205 |   | $ | 115,441 |   | $ | 65,411 |   | $ | 1,205 |   | $ | 66,616 |   |
| Operating costs  and expenses:                                   |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 88,073                                                                |       | — |   | 88,073 |   | 47,916 |   | — |   | 47,916 |   |
| Operations and  maintenance                                      |       | 7,271                                                                 |       | 280 |   | 7,551 |   | 4,783 |   | 197 |   | 4,980 |   |
| Depreciation and  amortization                                   |       | 8,561                                                                 |       | 895 |   | 9,456 |   | 6,431 |   | 895 |   | 7,326 |   |
| Bad debt                                                         |       | 8,103                                                                 |       | — |   | 8,103 |   | — |   | — |   | — |   |
| General and  administrative expenses                             |       | 2,314                                                                 |       | 19 |   | 2,333 |   | 2,244 |   | 41 |   | 2,285 |   |
|                                                             |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  costs and expenses                              |       | 114,322                                                               |       | 1,194 |   | 115,516 |   | 61,374 |   | 1,133 |   | 62,507 |   |
| Operating income  (loss)                                         |       | $                                                                     | (86        | ) | $ | 11 |   | (75 | ) | $ | 4,037 |   | $ | 72 |   | 4,109 |   |
| Other income  (expense):                                         |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Interest and  other income                                       |       |                                                                  |       |   |   | 73 |   |   |   |   |   | 93 |   |
| Amortization of  deferred loan costs                             |       |                                                                  |       |   |   | (168 | ) |   |   |   |   | (110 | ) |
| Interest expense                                                 |       |                                                                  |       |   |   | (3,130 | ) |   |   |   |   | (2,314 | ) |
| Minority  interest in loss (income) of Hiland Partners, LP       |       |                                                                  |       |   |   | (1,620 | ) |   |   |   |   | (639 | ) |
| Net income  (loss)                                               |       |                                                                  |       |   |   | $ | (1,108 | ) |   |   |   |   | $ | 1,139 |   |

 
| ** **                                                       | ** ** | **For the Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2008**                                                            | ** ** | **2007** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                       | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Segment**                                                         | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
| ** **                                                       | ** ** | ** **                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                         |       | $                                                                   | 204,510    |   | $ | 2,410 |   | $ | 206,920 |   | $ | 125,259 |   | $ | 2,410 |   | $ | 127,669 |   |
| Operating costs  and expenses:                                   |       |                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 156,691                                                             |       | — |   | 156,691 |   | 91,531 |   | — |   | 91,531 |   |
| Operations and  maintenance                                      |       | 13,811                                                              |       | 509 |   | 14,320 |   | 9,585 |   | 365 |   | 9,950 |   |
| Depreciation and  amortization                                   |       | 16,881                                                              |       | 1,790 |   | 18,671 |   | 12,563 |   | 1,789 |   | 14,352 |   |
| Bad debt                                                         |       | 8,103                                                               |       | — |   | 8,103 |   | — |   | — |   | — |   |
| General and  administrative expenses                             |       | 4,969                                                               |       | 49 |   | 5,018 |   | 4,248 |   | 82 |   | 4,330 |   |
| Total operating  costs and expenses                              |       | 200,455                                                             |       | 2,348 |   | 202,803 |   | 117,927 |   | 2,236 |   | 120,163 |   |
| Operating income                                                 |       | $                                                                   | 4,055      |   | $ | 62 |   | 4,117 |   | $ | 7,332 |   | $ | 174 |   | 7,506 |   |
| Other income  (expense):                                         |       |                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Interest and  other income                                       |       |                                                                |       |   |   | 177 |   |   |   |   |   | 219 |   |
| Amortization of  deferred loan costs                             |       |                                                                |       |   |   | (324 | ) |   |   |   |   | (220 | ) |
| Interest expense                                                 |       |                                                                |       |   |   | (6,636 | ) |   |   |   |   | (4,405 | ) |
| Minority  interest in loss (income) of Hiland Partners, LP       |       |                                                                |       |   |   | (1,414 | ) |   |   |   |   | (1,213 | ) |
| Net income (loss)                                                |       |                                                                |       |   |   | $ | (268 | ) |   |   |   |   | $ | 1,887 |   |

 

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**Note 12: Net Income (loss) per Limited Partners’Unit**

 

The computation of basicnet income (loss) per limited partners’ unit is based on the weighted-averagenumber of common units outstanding during the period. The computation ofdiluted earnings per unit further assumes the dilutive effect of restrictedunits. Net income (loss) per unit applicable to limited partners is computed bydividing net income (loss) applicable to limited partners by theweighted-average number of limited partnership units outstanding. The followingis a reconciliation of the limited partner units used in the calculations ofincome (loss) per limited partner unit—basic and income (loss) per limitedpartner unit—diluted assuming dilution for the three and six months ended June 30,2008 and 2007:

 
| ** **                                                            | ** ** | **For the Three Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2008**                                                              | ** ** | **2007** | ** ** |
| ** **                                                            | ** ** | **(Loss)**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Income** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Available to**                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Available to** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Limited**                                                           | ** ** | **Limited** | ** ** | ** ** | ** ** | **Limited** | ** ** | **Limited** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Partners**                                                          | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** | **Partners** | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                            | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Income (loss)per  limited partner unit -basic:                        |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss)  available to limited partners                          |       | $                                                                     | (1,108     | ) |   |   | $ | (0.05 | ) | $ | 1,139 |   |   |   | $ | 0.05 |   |
| Weighted average  limited partner units  outstanding                  |       |                                                                  |       | 21,603,000 |   |   |   |   |   | 21,600,000 |   |   |   |
| Income (loss)  per limited partner unit -diluted: Restricted units    |       |                                                                  |       | — |   |   |   |   |   | 6,000 |   |   |   |
| Income (loss)  available to limited partners plus assumed conversions |       | $                                                                     | (1,108     | ) | 21,603,000 |   | $ | (0.05 | ) | $ | 1,139 |   | 21,606,000 |   | $ | 0.05 |   |

 
| ** **                                                            | ** ** | **For the Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2008**                                                            | ** ** | **2007** | ** ** |
| ** **                                                            | ** ** | **(Loss)**                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Income** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Available to**                                               | ** ** | ** ** | ** ** | ** ** | ** ** | **Available to** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Limited**                                                         | ** ** | **Limited** | ** ** | ** ** | ** ** | **Limited** | ** ** | **Limited** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Partners**                                                        | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** | **Partners** | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                            | ** ** | **(Numerator)**                                                     | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Income (loss)per  limited partner unit -basic:                        |       |                                                                |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss)  available to limited partners                          |       | $(268                                                               | )          |   |   | $(0.01 | ) | $1,887 |   |   |   | $0.09 |   |
| Weighted average  limited partner units  outstanding                  |       |                                                                |       | 21,603,000 |   |   |   |   |   | 21,600,000 |   |   |   |
| Income (loss)  per limited partner unit -diluted: Restricted units    |       |                                                                |       | — |   |   |   |   |   | 6,000 |   |   |   |
| Income (loss)  available to limited partners plus assumed conversions |       | $(268                                                               | )          | 21,603,000 |   | $(0.01 | ) | $1,887 |   | 21,606,000 |   | $0.09 |   |

 

For each of the three andsix months ended March 31, 2008, approximately 8,000 restricted units wereexcluded from the computation of diluted earnings attributable to limitedpartner units because the inclusion of such units would have beenanti-dilutive.

 

**Note 13: ****Partners’ Equity and Cash Distributions**

 

***Hiland Holdings***

 

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, which provides that any units held by a person that owns20% 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.” Initially our only cash-generating assets 

 

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are our interests inHiland Partners from which we receive quarterly distributions. The amount ofavailable cash may be greater than or less than the minimum quarterlydistributions.

 

All distributions paid byHiland Holdings to common unitholders from January 1, 2007 forward,including amounts paid to affiliate owners, were as follows (in thousands,except per unit amounts):

 

| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** **          | ** ** |
|--------------------|------------|-----------------------------|------------|---------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Distribution**    | ** ** |
| 02/19/07           |       |                        | $          | 0.2075              |       | $ | 4,484 |   |
| 05/18/07           |       |                        | 0.2075     |                | 4,484      |   |
| 08/17/07           |       |                        | 0.2200     |                | 4,755      |   |
| 11/19/07           |       |                        | 0.2300     |                | 4,972      |   |
| 02/19/08           |       |                        | 0.2550     |                | 5,513      |   |
| 05/19/08           |       |                        | 0.2800     |                | 6,053      |   |
| 08/19/08           |  (a)  |                        | 0.3050     |                | 6,594      |   |
|               |       |                        | $          | 1.7050              |       | $ | 36,855 |   |

 

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(a)          Thiscash distribution was announced on July 25, 2008 and will be paid on August 19,2008 to all unitholders of record as of August 4, 2008.

 

***Hiland Partners***

 

The unitholders (limitedpartners) of Hiland Partners have only limited voting rights on mattersaffecting its operations and activities and, therefore, limited ability toinfluence its management’s decisions regarding its business. Unitholders didnot select Hiland Partners GP, LLC as general partner or elect its board ofdirectors and effectively have no right to select a general partner or electits board of directors in the future. Unitholders’ voting rights are furtherrestricted by Hiland Partners’ partnership agreement, which provides that anyunits held by a person that owns 20% or more of any class of units thenoutstanding, other than the general partner, its affiliates, their transfereesand persons who acquired such units with the prior approval of Hiland PartnersGP, LLC’s board of directors, cannot be voted on any matter. In addition,Hiland Partners’ partnership agreement contains provisions limiting the abilityof its unitholders to call meetings or to acquire information about itsoperations, as well as other provisions limiting a unitholder’s ability toinfluence the manner or direction of Hiland Partners’ management.

 

Hiland Partners’partnership agreement requires that it distribute all of its cash on hand atthe end of each quarter, less reserves established at Hiland Partners GP, LLC’sdiscretion. Hiland Partners refers to this as “available cash.” The amount ofavailable cash may be greater than or less than the minimum quarterlydistributions described below. In general, Hiland Partners will pay any cashdistribution made each quarter in the following manner:

 

·         first, 98%to the common units, pro rata, and 2% to Hiland Partners GP, LLC, until eachcommon unit has received a minimum quarterly distribution of $0.45 plus anyarrearages from prior quarters;

 

·         second, 98%to the subordinated units, pro rata, and 2% to Hiland Partners GP, LLC, untileach subordinated unit has received a minimum quarterly distribution of $0.45;and

 

·         third, 98%to all units, pro rata, and 2% to Hiland Partners GP, LLC, until each unit hasreceived a distribution of $0.495.

 

If cash distributions perunit exceed $0.495 in any quarter, Hiland Partners GP, LLC as general partnerwill receive increasing percentages, up to a maximum of 50% of the cash HilandPartners distributes in excess of that amount. Hiland Partners refers to thesedistributions 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 with respect tocertain portions of the subordinated units once Hiland Partners meets certainfinancial tests, but will not end with respect to all subordinated units beforeMarch 31, 2010. These financial tests require Hiland Partners to haveearned 

 

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and paid the minimum quarterly distribution on all of its outstandingunits for three consecutive four-quarter periods. When the subordination periodends, all remaining subordinated units will convert into common units on aone-for-one basis and the common units will no longer be entitled toarrearages. Following Hiland Partners’ distribution on May 14, 2008, thesefinancial tests were met for the immediate preceding three consecutivefour-quarter periods, and accordingly, 25%, or 1,020,000, of the subordinatedunits were converted to common units on May 19, 2008.

 

Presented below are cashdistributions to Hiland Partners common and subordinated unitholders, includingamounts to affiliate owners and regular and incentive distributions to HilandPartners GP, LLC paid by Hiland Partners from January 1, 2007 forward (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** | ** ** |
| 02/14/07           |       |                        | $          | 0.7125     |       | $                | 3,694      |                     | $          | 2,907               |       | $                | 150        |   | $ | 749 |   | $ | 7,500 |   |
| 05/15/07           |       |                        | 0.7125     |       | 3,724      |             | 2,907      |                     | 151        |                | 752        |             | 7,534      |   |
| 08/14/07           |       |                        | 0.7325     |       | 3,837      |             | 2,989      |                     | 158        |                | 932        |             | 7,916      |   |
| 11/14/07           |       |                        | 0.7550     |       | 3,959      |             | 3,080      |                     | 167        |                | 1,134      |             | 8,340      |   |
| 02/14/08           |       |                        | 0.7950     |       | 4,169      |             | 3,243      |                     | 182        |                | 1,492      |             | 9,086      |   |
| 05/14/08           |       |                        | 0.8275     |       | 4,364      |             | 3,376      |                     | 194        |                | 1,789      |             | 9,723      |   |
| 08/14/08           |  (a)  |                        | 0.8625     |       | 5,443      |             | 2,640      |                     | 208        |                | 2,106      |             | 10,397     |   |
|               |       |                        | $          | 5.3975     |       | $                | 29,190     |                     | $          | 21,142              |       | $                | 1,210      |   | $ | 8,954 |   | $ | 60,496 |   |

 

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(a)          Thiscash distribution was announced on July 25, 2008 and will be paid on August 14,2008 to all unitholders of record as of August 4, 2008.

 

Presented below are cashdistributions by Hiland Partners to us and Hiland Partners GP, LLC from January 1,2007 forward (in thousands, except per unit amounts):

 
| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|--------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
| 02/14/07           |       |                        | $          | 0.7125     |       | $                | 927        |                     | $          | 2,907               |       | $                | 150        |   | $ | 749 |   | $ | 4,733 |   |
| 05/15/07           |       |                        | 0.7125     |       | 927        |             | 2,907      |                     | 151        |                | 752        |             | 4,737      |   |
| 08/14/07           |       |                        | 0.7325     |       | 953        |             | 2,989      |                     | 158        |                | 932        |             | 5,032      |   |
| 11/14/07           |       |                        | 0.7550     |       | 983        |             | 3,080      |                     | 167        |                | 1,134      |             | 5,364      |   |
| 02/14/08           |       |                        | 0.7950     |       | 1,035      |             | 3,243      |                     | 182        |                | 1,492      |             | 5,952      |   |
| 05/14/08           |       |                        | 0.8275     |       | 1,077      |             | 3,376      |                     | 194        |                | 1,789      |             | 6,436      |   |
| 08/14/08           |  (a)  |                        | 0.8625     |       | 2,002      |             | 2,640      |                     | 208        |                | 2,106      |             | 6,956      |   |
|               |       |                        | $          | 5.3975     |       | $                | 7,904      |                     | $          | 21,142              |       | $                | 1,210      |   | $ | 8,954 |   | $ | 39,210 |   |

 

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(a)          Thiscash distribution was announced on July 25, 2008 and will be paid on August 14,2008 to all unitholders of record as of August 4, 2008.

 

**Note14:   Subsequent Event**

 

On July 22, 2008, SemGroup, L.P. and certainsubsidiaries filed voluntary petitions for reorganization under Chapter 11 ofthe U.S. Bankruptcy Code.  Affiliates ofSemGroup, L.P. purchase Hiland Partners’ natural gas liquids and condensate,primarily at its Bakken and Badlands plants and gathering systems.  As a result, Hiland Partners has increasedits allowance for doubtful accounts and bad debt expense by approximately $8.1million in the three and six month periods ended June 30, 2008.  Hiland Partners estimates additionalpotential exposure of approximately $5.0 million with this purchaser foruninvoiced product sales from July 1 through July 18, 2008.  Hiland Partners has made temporaryarrangements with other third parties for Hiland Partners’ product sales whileassessing its options in light of SemGroup’s bankruptcy.  Hiland Partners is monitoring the bankruptcycases closely to pursue the best course of action to obtain payment of theamounts owed to them and to continue natural gas liquids and condensate salesat Hiland Partners’ Bakken and Badlands plants and gathering systems.  This matter is not expected to cause HilandPartners to be out of compliance with its covenants under its credit facilityor impact Hiland Partners’ liquidity position in any material respect.

 

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**CautionaryStatement About Forward-Looking Statements**

 

This Quarterly Report on Form 10-Qincludes certain “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. These statements include 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 help identify forward-looking statements. Although webelieve such forward-looking statements are based on reasonable assumptions andcurrent expectations and projections about future events, no assurance can begiven that every objective will be reached.

 

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

 

·         the ability to pay distributions toour unitholders;

 

·         our expected receipt of distributionsfrom Hiland Partners;

 

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

 

·         thecontinued ability of Hiland Partners to find and contract for new sources ofnatural gas supply;

 

·         the amountof natural gas transported on Hiland Partners’ gathering systems;

 

·         the level ofthroughput in Hiland Partners’ natural gas processing and treating facilities;

 

·         the feesHiland Partners charges and the margins realized for its services;

 

·         the pricesand market 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;

 

·         actionstaken by foreign oil and gas producing nations;

 

·         thepolitical and economic stability of petroleum producing nations;

 

·         the weatherin Hiland Partners’ operating areas;

 

·         the extentof governmental 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;

 

·         the abilityto comply with the financial covenants contained in our or Hiland Partners’credit facilities;

 

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·         theavailability and cost of capital and our or Hiland Partners’ ability to accesscertain capital sources;

 

·         changes inlaws and regulations to which we and Hiland Partners are subject, includingtax, environmental, transportation and employment regulations;

 

·         the costsand effects of legal and administrative proceedings;

 

·         the abilityto successfully identify and consummate strategic acquisitions at purchaseprices that are accretive to the Hiland Partners’ financial results; and

 

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

 

These factors are notnecessarily all of the important factors that could cause our actual results todiffer materially from those expressed in any of our forward-looking statements.Our future results will depend upon various other risks and uncertainties,including, but not limited to those described above. Other unknown orunpredictable factors also could have material adverse effects on our futureresults. You should not place undue reliance on any forward-looking statements.

 

All forward-lookingstatements attributable to us are qualified in their entirety by thiscautionary statement. We undertake no duty to update our forward-lookingstatements to reflect the impact of events or circumstances after the date ofthe forward-looking statements.

 

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

 

Unless the contextrequires otherwise, references to “we”, “our,” “us,” “Hiland Holdings” or “thePartnership” are intended to mean the consolidated business and operations ofHiland Holdings GP, LP. References to “Hiland Partners” are intended to meanthe consolidated business and operations of Hiland Partners, LP and itssubsidiaries.

 

**Overviewof Hiland Holdings**

 

We are a Delaware limitedpartnership formed in May 2006 to own Hiland Partners GP, LLC, thegeneral partner of Hiland Partners, and certain other common and subordinatedunits in Hiland Partners We reflect our ownership interest in Hiland Partnerson a consolidated basis, which means that our financial results are combinedwith Hiland Partners’ financial results. The non-controlling limited partnerinterest in Hiland Partners is reflected as an expense in our results ofoperations and as a liability on our consolidated balance sheet. HilandPartners GP, LLC’s results of operations principally reflect the results ofoperations of Hiland Partners and are adjusted for non-controlling partners’interests in Hiland Partners’ net income.

 

Our cash generatingassets consist of our direct or indirect ownership interests in HilandPartners. Hiland Partners is principally engaged in purchasing, gathering,compressing, dehydrating, treating, processing and marketing of natural gas,fractionating and marketing of natural gas liquids and providing aircompression and water injection services for oil and gas secondary recoveryoperations. Our aggregate ownership interests in Hiland Partners consist of thefollowing:

 

·         the 2% general partner interest inHiland Partners;

·         100% of the incentive distributionrights in Hiland Partners; and

·         2,321,471 common units and 3,060,000subordinated units of Hiland Partners, representing a 57.5% limited partnerinterest in Hiland Partners.

 

Hiland Partners isrequired by its partnership agreement to distribute all of its cash on hand atthe end of each quarter, after establishing reserves to provide for the properconduct of its business or to provide funds for future distributions. HilandPartners announced its quarterly distribution to $0.8625 per unit for thequarter ended June 30, 2008. This distribution will be paid on August 14,2008 to unitholders of record on August 4, 2008.

 

Our primary objective isto increase our cash distributions to our unitholders by actively assistingHiland Partners in executing its business strategy. We intend to support HilandPartners in implementing its business strategy by assisting in identifying,evaluating and pursuing growth opportunities. In the future, it is possiblethat we may also support the growth of 

 

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Hiland Partners throughthe use of our capital resources, which could involve loans or capitalcontributions to Hiland Partners to provide funding for the acquisition of abusiness or an asset or for an internal growth project. In addition, we mayprovide Hiland Partners with other forms of credit support, such as guaranteesrelating to financing a project or other types of support related to a mergeror acquisition transaction.

 

*Cash Distributions.  * Thefollowing table sets forth the distributions that we have received from HilandPartners during the periods indicated.

 
| ** **                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **Hiland Partner’s Distributions**            | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Common units                                                 |       | $                                                   | 1,077      |                                              | $          | 927 |   | $ | 2,111 |   | $ | 1,854 |   |
| Subordinated  units                                          |       | 3,376                                               |       | 2,907                                             |       | 6,620 |   | 5,814 |   |
| Ownership  interest in Hiland Partners’ general partner |       | 194                                                 |       | 151                                               |       | 376 |   | 301 |   |
| General  partners’ incentive distribution rights        |       | 1,789                                               |       | 752                                               |       | 3,281 |   | 1,501 |   |
|                                                         |       | $                                                   | 6,436      |                                              | $          | 4,737 |   | $ | 12,388 |   | $ | 9,470 |   |

 

Becausewe own Hiland Partners GP, LLC, the distributions to us include thedistributions made to Hiland Partners GP, LLC.

 

**Overview of Hiland Partners**

 

Hiland Partners isengaged in purchasing, gathering, compressing, dehydrating, treating,processing and marketing of natural gas, fractionating and marketing of NGLsand providing air compression and water injection services for oil and gassecondary recovery operations. Hiland Partners’ operations are primarilylocated in the Mid-Continent and Rocky Mountain regions of the United States.

 

Hiland Partners managesits business and analyzes and reports its results of operations on a segmentbasis. Hiland Partners’ operations are divided into two business segments:

 

·    *MidstreamSegment,* which is engaged in purchasing, gathering, compressing,dehydrating, treating, processing and marketing of natural gas andfractionating and marketing of NGLs. The midstream segment generated 95.6% and93.6% of total segment margin for the three months ended June 30, 2008 and2007, respectively, and 95.2% and 93.3% of total segment margin for the sixmonths ended June 30, 2008 and 2007, respectively.

 

·    *CompressionSegment,* which is engaged in providing air compression and waterinjection services for oil and gas secondary recovery operations that areongoing in North Dakota. The compression segment generated 4.4% and 6.4% oftotal segment margin for the three months ended June 30, 2008 and 2007,respectively, and 4.8% and 6.7% of total segment margin for the six monthsended June 30, 2008 and 2007, respectively.

 

Hiland Partners’midstream assets currently consist of 14 natural gas gathering systems withapproximately 2,079 miles of gas gathering pipelines, five natural gasprocessing plants, seven natural gas treating facilities and three NGLfractionation facilities.  HilandPartners’ compression assets consist of two air compression facilities and a waterinjection plant.

 

Hiland Partners’ resultsof operations are determined primarily by five interrelated variables: (1) thevolume of natural gas gathered through its pipelines; (2) the volume ofnatural gas processed; (3) the volume of NGLs fractionated; (4) thelevels and relationship of natural gas and NGL prices; and (5) HilandPartners’ current contract portfolio. Because Hiland Partners’ profitability isa function of the difference between the revenues it receives from itsoperations, including revenues from the products it sells, and the costsassociated with conducting its operations, including the costs of products itpurchases, increases or decreases in Hiland Partners’ revenues alone are notnecessarily indicative of increases or decreases in its profitability. To alarge extent, Hiland Partners’ contract portfolio, the pricing environment fornatural gas and NGLs and the price of NGLs relative to natural gas prices willdictate increases or decreases in its profitability. Hiland Partners’ profitabilityis also dependent upon prices and market demand for natural gas and NGLs, whichfluctuate with changes in market and economic conditions and other factors.

 

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**Recent Events**

 

*OfficerSelection and Re-Alignment. *OnAugust 4, 2008, we appointed Mr. Kent C. ChristophersonVice-President – Chief Operations Officer. On August 7, 2008, we appointedMr. Robert Shain to Vice-President – Chief Commercial Officer fromVice-President – Operations and Engineering.

 

*DistributionIncrease.  *On July 25,2008, we declared a cash distribution for the second quarter of 2008. Thisdeclared quarterly distribution on ourcommon units increased to $0.305 per unit (an annualized rate of $1.22 perunit) from our most recent distribution of $0.28 per unit (an annualized rateof $1.12 per unit). This represents a 8.9% increase over the prior quarter anda 38.6% increase over the distribution for the same quarter of the prior year.The distribution will be paid on August 19, 2008 to unitholders of recordon August 4, 2008.

 

*Significant Trade AccountReceivable. *On July 22,2008, SemGroup, L.P. and certain subsidiaries filed voluntary petitions forreorganization under Chapter 11 of the U.S. Bankruptcy Code.  Affiliates of SemGroup, L.P. purchase HilandPartners’ natural gas liquids and condensate, primarily at its Bakken andBadlands plants and gathering systems. As a result, Hiland Partners has increased its allowance for doubtfulaccounts and bad debt expense by approximately $8.1 million in the three andsix month periods ended June 30, 2008. Hiland Partners estimates additional potential exposure of approximately$5.0 million with this purchaser for uninvoiced product sales from July 1through July 18, 2008.  HilandPartners has made temporary arrangements with other third parties for HilandPartners’ product sales while assessing its options in light of SemGroup’sbankruptcy.  Hiland Partners ismonitoring the bankruptcy cases closely to pursue the best course of action toobtain payment of the amounts owed to them and to continue natural gas liquidsand condensate sales at Hiland Partners’ Bakken and Badlands plants andgathering systems.  This matter is notexpected to cause Hiland Partners to be out of compliance with its covenantsunder its credit facility or impact Hiland Partners’ liquidity position in anymaterial respect.

 

*FinancialHedge Agreement. *On May 27,2008 Hiland Partners entered into a cash flow swap agreement with an investmentgrade counterparty to sell 178,000 MMBtu per month at a fixed price of $10.50per MMBtu for the calendar year 2010.

 

*OrganicGrowth Projects.* During the second quarter 2008, HilandPartners entered into an agreement with CLR to construct and operate gatheringpipelines, processing plants and related facilities in the Bakken Shale play innorthwestern North Dakota in which CLR has dedicated approximately 129,000gross acres to Hiland Partners. The initial term of the agreement is for 10years and grants Hiland Partners the right to process natural gas, share in thesales proceeds of the natural gas liquids and residue gas and receive certainfixed fees for treating the natural gas. Hiland Partners plans to make aninitial capital investment of approximately $10.0 million by the end of 2008with additional investments of up to $17.0 million over the next three years tobuild processing and treating facilities and install field gathering, compressionand associated equipment.  The expectedstartup of the initial phase of the project should occur no later than thesecond quarter of 2009.

 

         Additionally, Hiland Partners hasaccelerated the expansion of the Woodford Shale gathering system and plans toexpand the system’s capacity to over 65,000 Mcf/d by the end of the thirdquarter of 2008. Hiland Partners estimates a capital investment ofapproximately $10.0 million to complete the expansion.

 

**Historical Results of Operations**

 

Our historical results ofoperations for the periods presented may not be comparable, either from periodto period or going forward due to increased volumes and associated operatingexpenses at Hiland Partners’ Badlands gathering system as a result of theconstruction of Hiland Partners’ nitrogen rejection plant which becameoperational in August 2007 and volumes and operating expenses at HilandPartners’ Woodford Shale gathering system which commenced operation in April 2007.

 

**Our Results of Operations**

 

The results of ouroperations discussed below principally reflect the activities of HilandPartners. Because our consolidated financial statements include the results ofHiland Partners, our financial statements are substantially similar to thefinancial statements of Hiland Partners. However, our consolidated balancesheet includes a minority interest amount that reflects the proportion ofHiland Partners owned by its unitholders other than us. Similarly, theownership interests in Hiland Partners held by its unitholders other than usare reflected in our consolidated income (loss) statement as minority interest.The minority interest amounts are not reflected on Hiland Partners’ financialstatements.

 

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Set forth in the tablesbelow are certain financial and operating data for the periods indicated.

 
| ** **                                                                      | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| ** **                                                                      | ** ** | **(in thousands)**                             | ** ** |
| **Total  Segment Margin Data:**                                                 |       |                                                |       |   |   |
| Midstream  revenues                                                             |       | $                                                   | 114,236    |   | $ | 65,411 |   |
| Midstream  purchases                                                            |       | 88,073                                              |       | 47,916 |   |
| Midstream  segment margin                                                       |       | 26,163                                              |       | 17,495 |   |
| Compression  revenues (1)                                                       |       | 1,205                                               |       | 1,205 |   |
| Total segment  margin (2)                                                       |       | $                                                   | 27,368     |   | $ | 18,700 |   |
|                                                                            |       |                                                |       |   |   |
| **Summary  of Operations Data:**                                                |       |                                                |       |   |   |
| Midstream  revenues                                                             |       | $                                                   | 114,236    |   | $ | 65,411 |   |
| Compression  revenues                                                           |       | 1,205                                               |       | 1,205 |   |
| Total revenues                                                                  |       | 115,441                                             |       | 66,616 |   |
|                                                                            |       |                                                |       |   |   |
| Midstream  purchases (exclusive of items shown separately below)                |       | 88,073                                              |       | 47,916 |   |
| Operations and  maintenance                                                     |       | 7,551                                               |       | 4,980 |   |
| Depreciation,  amortization and accretion                                       |       | 9,456                                               |       | 7,326 |   |
| Bad Debt                                                                        |       | 8,103                                               |       | — |   |
| General and  administrative                                                     |       | 2,333                                               |       | 2,285 |   |
| Total operating  costs and expenses                                             |       | 115,516                                             |       | 62,507 |   |
| Operating income  (loss)                                                        |       | (75                                                 | )          | 4,109 |   |
| Other income  (expense), net                                                    |       | (3,225                                              | )          | (2,331 | ) |
| Income (loss)  before minority interest in loss (income) of Hiland Partners, LP |       | (3,300                                              | )          | 1,778 |   |
| Minority  interest in loss (income) of Hiland Partners, LP                      |       | 2,192                                               |       | (639 | ) |
| **Net  income (loss)**                                                          |       | $                                                   | (1,108     | ) | $ | 1,139 |   |
|                                                                            |       |                                                |       |   |   |
| **Hiland  Partners Operating Data:**                                            |       |                                                |       |   |   |
| Inlet natural  gas (MCF/d)                                                      |       | 246,339                                             |       | 212,595 |   |
| Natural gas  sales (MMBTU/d)                                                    |       | 86,203                                              |       | 78,085 |   |
| NGL sales  (Bbls/d)                                                             |       | 5,979                                               |       | 4,304 |   |

 

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| ** **                                                                      | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| ** **                                                                      | ** ** | **(in thousands)**                           | ** ** |
| **Total  Segment Margin Data:**                                                 |       |                                              |       |   |   |
| Midstream  revenues                                                             |       | $                                                 | 204,510    |   | $ | 125,259 |   |
| Midstream  purchases                                                            |       | 156,691                                           |       | 91,531 |   |
| Midstream  segment margin                                                       |       | 47,819                                            |       | 33,728 |   |
| Compression  revenues (1)                                                       |       | 2,410                                             |       | 2,410 |   |
| Total segment  margin (2)                                                       |       | $                                                 | 50,229     |   | $ | 36,138 |   |
|                                                                            |       |                                              |       |   |   |
| **Summary  of Operations Data:**                                                |       |                                              |       |   |   |
| Midstream  revenues                                                             |       | $                                                 | 204,510    |   | $ | 125,259 |   |
| Compression  revenues                                                           |       | 2,410                                             |       | 2,410 |   |
| Total revenues                                                                  |       | 206,920                                           |       | 127,669 |   |
|                                                                            |       |                                              |       |   |   |
| Midstream  purchases (exclusive of items shown separately below)                |       | 156,691                                           |       | 91,531 |   |
| Operations and  maintenance                                                     |       | 14,321                                            |       | 9,950 |   |
| Depreciation,  amortization and accretion                                       |       | 18,671                                            |       | 14,352 |   |
| Bad Debt                                                                        |       | 8,103                                             |       | — |   |
| General and  administrative                                                     |       | 5,017                                             |       | 4,330 |   |
| Total operating  costs and expenses                                             |       | 202,803                                           |       | 120,163 |   |
| Operating income                                                                |       | 4,117                                             |       | 7,506 |   |
| Other income  (expense), net                                                    |       | (6,783                                            | )          | (4,406 | ) |
| Income (loss)  before minority interest in loss (income) of Hiland Partners, LP |       | (2,666                                            | )          | 3,100 |   |
| Minority  interest in loss (income) of Hiland Partners, LP                      |       | 2,398                                             |       | (1,213 | ) |
| **Net  income (loss)**                                                          |       | $                                                 | (268       | ) | $ | 1,887 |   |
|                                                                            |       |                                              |       |   |   |
| **Hiland  Partners Operating Data:**                                            |       |                                              |       |   |   |
| Inlet natural  gas (MCF/d)                                                      |       | 236,885                                           |       | 206,376 |   |
| Natural gas  sales (MMBTU/d)                                                    |       | 86,174                                            |       | 76,313 |   |
| NGL sales  (Bbls/d)                                                             |       | 5,626                                             |       | 4,146 |   |

 

----

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

 

(2) Reconciliationof total segment margin to operating income:

 
| ** **                                                             | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                             | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**                             | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Income (loss)** |       |                                                |       |   |   |
| Operating income  (loss)                                               |       | $                                                   | (75        | ) | $ | 4,109 |   |
| Add:                                                                   |       |                                                |       |   |   |
| Operations and  maintenance expenses                                   |       | 7,551                                               |       | 4,980 |   |
| Depreciation,  amortization and accretion                              |       | 9,456                                               |       | 7,326 |   |
| Bad debt                                                               |       | 8,103                                               |       | — |   |
| General and  administrative expenses                                   |       | 2,333                                               |       | 2,285 |   |
| Total segment  margin                                                  |       | $                                                   | 27,368     |   | $ | 18,700 |   |

 
| ** **                                                      | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                      | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| ** **                                                      | ** ** | **(in thousands)**                           | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Income** |       |                                              |       |   |   |
| Operating income                                                |       | $                                                 | 4,117      |   | $ | 7,506 |   |
| Add:                                                            |       |                                              |       |   |   |
| Operations and  maintenance expenses                            |       | 14,321                                            |       | 9,950 |   |
| Depreciation,  amortization and accretion                       |       | 18,671                                            |       | 14,352 |   |
| Bad debt                                                        |       | 8,103                                             |       | — |   |
| General and  administrative expenses                            |       | 5,017                                             |       | 4,330 |   |
| Total segment  margin                                           |       | $                                                 | 50,229     |   | $ | 36,138 |   |

 

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We view total segmentmargin, a non-GAAP financial measure, as an important performance measure ofthe core profitability of our operations. We review total segment marginmonthly for a consistency and trend analysis. We define midstream segmentmargin as midstream revenue less midstream purchases. Midstream purchasesinclude the following costs and expenses: cost of natural gas and NGLspurchased by us from third parties, cost of natural gas and NGLs purchased byus 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.

 

**Three Months Ended June 30,2008 Compared with Three Months Ended June 30, 2007**

 

***Revenues.***  Total revenues(midstream and compression) were $115.4 million for the three months ended June 30,2008 compared to $66.6 million for the three months ended June 30, 2007,an increase of $48.8 million, or 73.3%.  This $48.8 million increase wasprimarily due to (i) increased natural gas sales volumes of 12,109MMBtu/day (MMBtu per day) and increased NGL sales volumes of 1,020 Bbls/day(Bbls per day) related to the Woodford Shale gathering system which commencedoperation in April 2007, (ii) increased NGL sales volumes of 790Bbls/day attributable to the expanded Badlands gathering system, including thenitrogen rejection plant, which commenced operation in August 2007 and (iii) significantlyhigher average realized natural gas and NGL sales prices for the three monthsended June 30, 2008 as compared to the same period in 2007, resulting inincreased revenues for all of the gathering systems.  Revenues fromcompression assets were the same for both periods.

 

Midstream revenues were$114.2 million for the three months ended June 30, 2008 compared to $65.4million for the three months ended June 30, 2007, a net increase of $48.8million, or 74.6%. Of this $48.8 million increase in midstream revenues,approximately $11.3 million was attributable to revenues from increased naturalgas and NGL sales volumes at the Woodford Shale, Badlands, Bakken and Matligathering systems and approximately $37.5 million was attributable tosignificantly higher average realized natural gas and NGL sales prices for thethree months ended June 30, 2008 as compared to the same period in 2007,resulting in increased revenues for all of the gathering systems.

 

Inlet natural gas was246,339 Mcf/d (Mcf per day) for the three months ended June 30, 2008 comparedto 212,595 Mcf/d for the three months ended June 30, 2007, a net increaseof 33,744 Mcf/d, or 15.9%.  This increaseis primarily attributable to volume growth at the Woodford Shale and Badlandsgathering systems offset by volume declines at the Eagle Chief and Kintagathering systems.

 

Natural gas sales volumeswere 86,203 MMBtu/d for the three months ended June 30, 2008 compared to78,085 MMBtu/d for the three months ended June 30, 2007, a net increase of8,118 MMBtu/d, or 10.4%.  This 8,118 MMBtu/d net increase in natural gassales volumes was attributable to increased natural gas sales volumes at theWoodford Shale, Bakken and Matli gathering systems offset by reduced naturalgas sales volumes at the Eagle Chief and Kinta gathering systems. NGL sales volumeswere 5,979 Bbls/d for the three months ended June 30, 2008 compared to4,304 Bbls/d for the three months ended June 30, 2007, a net increase of1,675 Bbls/d, or 38.9%.  This net increase is primarily attributable tovolume growth at the Woodford Shale and Badlands gathering systems.

 

Average realized naturalgas sales prices were $9.29 per MMBtu for the three months ended June 30,2008 compared to $6.03 per MMBtu for the three months ended June 30, 2007,an increase of $3.25 per MMBtu, or 54.0%.  Average realized NGL salesprices were $1.64 per gallon for the three months ended June 30, 2008compared to $1.09 per gallon for the three months ended June 30, 2007, anincrease of $0.55 per gallon or 50.1%.  The increase in the averagerealized natural gas and NGL sales prices was primarily a result ofsignificantly higher index prices for natural gas and posted prices for NGLsduring the three months ended June 30, 2008 compared to the three monthsended June 30, 2007.

 

Cash received from acounterparty on cash flow swap contracts for natural gas derivativetransactions that closed during the three months ended June 30, 2008totaled $0.1 million compared to $1.4 million for the three months ended June 30,2007.  The $0.1 million gain was immaterial to average realized naturalgas sales prices for the three months ended June 30, 2008.  The $1.4 million gain for the three monthsended June 30, 2007 increased averaged realized natural gas prices to$6.03 per MMBtu from $5.84 per MMBtu, an increase of $0.19 per MMBtu.  Cash paid to a counterparty on cash flow swapcontracts for NGL derivative transactions that closed during the three monthsended June 30, 2008 totaled $3.1 million compared to $0.5 million for thethree months ended June 30, 2007.   The $3.1 million loss forthe three months ended June 30, 2008 reduced averaged realized NGL pricesto $1.64 per gallon from $1.76 per MMBtu, a decrease of $0.12 per gallon. 

 

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The $0.5 million loss forthe three months ended June 30, 2007 reduced averaged realized NGL pricesto $1.09 per gallon from $1.11 per MMBtu, a decrease of $0.02 per gallon.

 

Compression revenues were$1.2 million for the each of the three months ended June 30, 2008 and2007.

 

***Midstream Purchases.***  Midstreampurchases were $88.1 million for the three months ended June 30, 2008compared to $47.9 million for the three months ended June 30, 2007, anincrease of $40.2 million, or 83.8%.  The $40.2 million increase isprimarily due to volume growth at the Woodford Shale gathering system whichcommenced operation in April 2007, the expanded Badlands gathering system,including the nitrogen rejection plant, which commenced operation in August 2007and higher natural gas and NGL purchase prices, resulting in increasedmidstream purchases for all of our gathering systems.

 

***Midstream Segment Margin .*** Midstream segment margin was $26.2 million for the three months ended June 30,2008 compared to $17.5 million for the three months ended June 30, 2007,an increase of $8.7 million, or 50.0%. The increase is primarily due to favorable gross processing spreads,significantly higher average realized natural gas and NGL prices, volume growthat the Woodford Shale gathering system which commenced operation in April 2007and volume growth at the expanded Badlands gathering system, including thenitrogen rejection plant, which commenced operation in August 2007. As apercent of midstream revenues, midstream segment margin was 22.9% and 26.7% forthe three months ended June 30, 2008 and 2007, respectively, a reductionof 3.8%.  This reduction is attributableto net losses on closed/settled derivative transactions and unrealized non-cashlosses on derivative transactions for the three months ended June 30,2008, including an unrealized non-cash loss of $1.5 million related to anon-qualifying mark-to-market cash flow hedge for forecasted sales in 2010,compared to net gains on closed/settled derivative transactions and unrealizednon-cash gains on derivative transactions for the three months ended June 30,2007.

 

***Operations and Maintenance.*** Operations and maintenance expense totaled $7.6 million for the three monthsended June 30, 2008 compared with $5.0 million for the three months ended June 30,2007, an increase of $2.6 million, or 51.6%. Of this increase, $1.5 million wasattributable to increased operations and maintenance at the expanded Badlandsgathering system and $0.9 million was attributable to increased operations andmaintenance at the Bakken, Eagle Chief, Matli and Woodford Shale gatheringsystems.

 

***Depreciation, Amortization and Accretion.*** Depreciation, amortization and accretion expense totaled $9.5 million for thethree months ended June 30, 2008 compared with $7.3 million for the threemonths ended June 30, 2007, an increase of $2.1 million, or 29.0 %. Of this increase, $0.8 million was attributable to increased depreciation onthe expanded Badlands gathering system, $0.4 million was attributable toincreased depreciation on the Bakken gathering system and another $0.5 millionwas attributable to the Woodford Shale gathering system.

 

***Bad Debt.***  For the three monthsended June 30, 2008 Hiland Partners has determined that collection of atrade accounts receivable from a significant customer totaling $8.1 million isdoubtful. Accordingly, Hiland Partners has increased its reserve for doubtfulaccounts and recorded a bad debt expense of $8.1 million. Hiland Partnersestimates additional potential exposure of approximately $5.0 million from thiscustomer for uninvoiced product sales from July 1, 2008 through July 18,2008. Neither we nor Hiland Partners had a bad debt for the three months ended June 30,2007.

 

***General and Administrative.*** General and administrative expense totaled $2.3 million for each of the threemonths ended June 30, 2008 and 2007. Salaries expense increased by $0.4million as a result of increased non-cash unit based compensation and decreasedcapitalized labor during the three months ended June 30, 2008 as comparedto the three months ended June 30, 2007. Salaries expense decreased by$0.2 million due to the timing of payments of current year executive bonuses,which were paid in the three months ended March 31, 2008 as compared toprior years’ executive bonuses, which were paid in the three months ended June 30,2007. General and administrative expense decreased as a result of incurring$0.2 million of acquisition evaluation costs in the three months ended June 30,2007 that were non-existent in the three months ended June 30, 2008.

 

***Other Income (Expense).*** Otherincome (expense) totaled ($3.2) million for the three months ended June 30,2008 compared with ($2.3) million for the three months ended June 30,2007, an increase in expense of $0.9 million.  The increase is primarilyattributable to additional interest expense from borrowings on Hiland Partners’credit facility to fund the expansion project at the Badlands gathering systemand to construct the Woodford Shale gathering system.

 

***Minority Interest.  ***Minority interest in income of Hiland Partners, which represents the allocationof Hiland Partners loss or earnings to its limited partner interests not ownedby Hiland Holdings, totaled $1.6 million for the three months ended June 30,2008 compared to $0.6 million for the three months ended June 30, 2007, anincrease of $1.0 million, or 153.5%.

 

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**SixMonths Ended June 30, 2008 Compared with Six Months Ended June 30,2007**

 

***Revenues.***  Total revenues(midstream and compression) were $206.9 million for the six months ended June 30,2008 compared to $127.7 million for the six months ended June 30, 2007, anincrease of $79.3 million, or 62.1%.  This $79.3 million increase wasprimarily due to (i) increased natural gas sales volumes of 13,162MMBtu/day (MMBtu per day) and increased NGL sales volumes of 1,043 Bbls/day(Bbls per day) related to the Woodford Shale gathering system which commencedoperation in April 2007, (ii) increased NGL sales volumes of 523Bbls/day attributable to the expanded Badlands gathering system, including thenitrogen rejection plant, which commenced operation in August 2007 and (iii) significantlyhigher average realized natural gas and NGL sales prices for the six monthsended June 30, 2008 as compared to the same period in 2007, resulting inincreased revenue at all of the gathering systems.  Revenues fromcompression assets were the same for both periods.

 

Midstream revenues were$204.5 million for the six months ended June 30, 2008 compared to $125.3million for the six months ended June 30, 2007, a net increase of $79.3million, or 63.3%. Of this $79.3 million increase in midstream revenues,approximately $22.7 million was attributable to revenues from increased naturalgas and NGL sales volumes at the Woodford Shale, Badlands, Bakken and Matligathering systems and approximately $56.5 million was attributable tosignificantly higher average realized natural gas and NGL sales prices for thethree months ended June 30, 2008 as compared to the same period in 2007,resulting in increased revenues for all of the gathering systems.

 

Inlet natural gas was236,885 Mcf/d (Mcf per day) for the six months ended June 30, 2008compared to 206,376 Mcf/d for the six months ended June 30, 2007, a netincrease of 30,509 Mcf/d, or 14.8%.  Thisincrease is primarily attributable to volume growth at the Woodford Shale andBadlands gathering systems offset by volume declines at the Eagle Chief andKinta gathering systems.

 

Natural gas sales volumeswere 86,174 MMBtu/d for the six months ended June 30, 2008 compared to76,313 MMBtu/d for the six months ended June 30, 2007, a net increase of9,861 MMBtu/d, or 12.9%.  This 9,861 MMBtu/d net increase in natural gassales volumes was attributable to increased natural gas sales volumes at theWoodford Shale, Bakken and Matli gathering systems offset by reduced naturalgas sales volumes at the Eagle Chief and Kinta gathering systems. NGL salesvolumes were 5,626 Bbls/d for the six months ended June 30, 2008 comparedto 4,146 Bbls/d for the six months ended June 30, 2007, a net increase of1,480 Bbls/d, or 35.7%.  This net increase is primarily attributable tovolume growth at the Woodford Shale and Badlands gathering systems.

 

Average realized naturalgas sales prices were $8.29 per MMBtu for the six months ended June 30,2008 compared to $6.11 per MMBtu for the six months ended June 30, 2007,an increase of $2.18 per MMBtu, or 35.7%.  Average realized NGL salesprices were $1.53 per gallon for the six months ended June 30, 2008compared to $1.02 per gallon for the six months ended June 30, 2007, anincrease of $0.51 per gallon or 50.0%.  The increase in the averagerealized natural gas and NGL sales prices was primarily a result ofsignificantly higher index prices for natural gas and posted prices for NGLsduring the six months ended June 30, 2008 compared to the six months endedJune 30, 2007.

 

Cash received from acounterparty on cash flow swap contracts for natural gas derivativetransactions that closed during the six months ended June 30, 2008 totaled$0.2 million compared to $2.0 million for the six months ended June 30,2007.  The $0.2 million gain for the six months ended June 30, 2008increased averaged realized natural gas prices to $8.29 per MMBtu from $8.28per MMBtu, an increase of $0.01 per MMBtu. The $2.0 million gain for the six months ended June 30, 2007increased averaged realized natural gas prices to $6.11 per MMBtu from $5.97per MMBtu, an increase of $0.0914 per MMBtu. Cash paid to a counterparty on cash flow swap contracts for NGLderivative transactions that closed during the six months ended June 30,2008 totaled $5.3 million compared to $0.5 million for the six months ended June 30,2007.   The $5.3 million loss for the six months ended June 30,2008 reduced averaged realized NGL prices to $1.53 per gallon from $1.64 perMMBtu, a decrease of $0.11 per gallon. The $0.5 million loss for the six monthsended June 30, 2007 had less than $0.01 per gallon effect on the averagerealized NGL price of $0.94 per gallon.

 

Compression revenues were$2.4 million for the each of the six months ended June 30, 2008 and 2007.

 

***Midstream Purchases.***  Midstreampurchases were $156.7 million for the six months ended June 30, 2008compared to $91.5 million for the six months ended June 30, 2007, anincrease of $65.2 million, or 71.2%.  The $65.2 million increase isprimarily due to volume growth at the Woodford Shale gathering system whichcommenced operation in April 2007, the expanded Badlands gathering system,including the nitrogen rejection plant, which commenced operation in August 2007and higher natural gas and NGL purchase prices, resulting in increasedmidstream purchases for all of our gathering systems.

 

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***Midstream Segment Margin.*** Midstream segment margin was $47.8 million for the six months ended June 30,2008 compared to $33.7 million for the six months ended June 30, 2007, anincrease of $14.1 million, or 41.8%.  Theincrease is primarily due to favorable gross processing spreads, significantlyhigher average realized natural gas and NGL prices, volume growth at theWoodford Shale gathering system which commenced operation in April 2007and volume growth at the expanded Badlands gathering system, including thenitrogen rejection plant, which commenced operation in August 2007. As apercent of midstream revenues, midstream segment margin was 23.4% and 26.9% forthe six months ended June 30, 2008 and 2007, respectively, a reduction of3.5%.  This reduction is attributable tonet losses on closed/settled derivative transactions and unrealized non-cashlosses on derivative transactions for the three months ended June 30,2008, including an unrealized non-cash loss of $1.5 million related to anon-qualifying mark-to-market cash flow hedge for forecasted sales in 2010,compared to net gains on closed/settled derivative transactions and unrealizednon-cash gains on derivative transactions for the three months ended June 30,2007. The increase in midstream segment margin was offset by approximately $2.3million of forgone margin as a result of the Badlands nitrogen rejection plantbeing temporarily taken out of service due to equipment failure during the sixmonths ended June 30, 2008.

 

***Operations and Maintenance.*** Operations and maintenance expense totaled $14.3 million for the six monthsended June 30, 2008 compared with $10.0 million for the six months ended June 30,2007, an increase of $4.4 million, or 43.9%. Of this increase, $2.4 million wasattributable to increased operations and maintenance at the expanded Badlandsgathering system and $1.6 million was attributable to increased operations andmaintenance at the Bakken, Eagle Chief, Matli and Woodford Shale gatheringsystems.

 

***Depreciation, Amortization and Accretion.*** Depreciation, amortization and accretion expense totaled $18.6 million for thesix months ended June 30, 2008 compared with $14.4 million for the sixmonths ended June 30, 2007, an increase of $4.3 million, or 30.1 %. Of this increase, $1.6 million was attributable to increased depreciation onthe expanded Badlands gathering system, $1.0 million was attributable to theWoodford Shale gathering system and $0.8 million was attributable to increaseddepreciation on the Bakken gathering system.

 

***Bad Debt.***  For the six monthsended June 30, 2008 Hiland Partners has determined that collection of atrade accounts receivable from a significant customer totaling $8.1 million isdoubtful. Accordingly, Hiland Partners has increased its reserve for doubtfulaccounts and recorded a bad debt expense of $8.1 million. Hiland Partnersestimates additional potential exposure of approximately $5.0 million from thiscustomer for uninvoiced product sales from July 1, 2008 through July 18,2008. Neither we nor Hiland Partners had a bad debt for the six months ended June 30,2007.

 

***General and Administrative.*** General and administrative expense totaled $5.0 million for the six monthsended June 30, 2008 compared with $4.3 million for the six months ended June 30,2007, an increase of $0.7 million. General and administrative expensesincreased by $0.8 million in the six months ended June 30, 2008 ascompared to the six months ended June 30, 2007 due to increased taxpreparation and audit related fees, increased non-cash unit based compensation,reduced capitalized labor and additional staffing, offset by a reduction of$0.2 million of acquisition evaluation costs incurred in the six months ended June 30,2007 that were non-existent in the six months ended June 30, 2008.

 

***Other Income (Expense).*** Otherincome (expense) totaled ($6.8) million for the six months ended June 30,2008 compared with ($4.4) million for the six months ended June 30, 2007,an increase in expense of $2.4 million.  The increase is primarilyattributable to additional interest expense from borrowings on Hiland Partners’credit facility to fund the expansion project at the Badlands gathering systemand to construct the Woodford Shale gathering system.

 

***Minority Interest.  ***Minority interest in income of Hiland Partners, which represents the allocationof Hiland Partners loss or earnings to its limited partner interests not ownedby Hiland Holdings totaled $1.4 million for the six months ended June 30,2008 compared to $1.2 million for the six months ended June 30, 2007, anincrease of $0.2 million, or 16.6%.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

***Overview***

 

We rely on distributionsfrom Hiland Partners to fund cash requirements for our operations. Cashgenerated from operations, borrowings under Hiland Partners’ credit facilityand funds from private or public equity and future debt offerings havehistorically been Hiland Partners’ primary sources of liquidity. We believethat funds from these sources should be sufficient to meet both Hiland Partners’short-term working capital requirements and its long-term capital expenditurerequirements. Hiland Partners’ ability to pay distributions to unitholders, tofund planned capital expenditures and to make acquisitions depends upon HilandPartners’ future operating performance and, more broadly, on the availabilityof equity and 

 

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debt financing, whichwill be affected by prevailing economic conditions in Hiland Partners’ industryand financial, business and other factors, many of which are beyond HilandPartners’ control.

 

***Cash Flows from Operating Activities***

 

 Cash flows from operating activities increasedby $2.8 million to $22.0 million for the six months ended June 30, 2008from $19.2 million for the six months ended June 30, 2007.  Duringthe six months ended June 30, 2008 we received cash flows from customersof approximately $184.3 million attributable to increased natural gas and NGLsvolumes and significantly higher average realized natural gas and NGL salesprices, had cash payments to our suppliers and employees of approximately$155.9 million and payment of interest expense of $6.4 million, net of amountscapitalized, resulting in cash received from operating activities of $22.0million. During the same six month period in 2007, we received cash flows fromcustomers of approximately $126.1 million attributable to increased volumes ofnatural gas and NGLs decreased by lower natural gas and NGL sales prices, hadcash payments to our suppliers and employees of approximately $102.5 millionand payment of interest expense of $4.4 million, net of amounts capitalized,resulting in cash received from our operating activities of $19.2 million.Changes in cash receipts and payments are primarily due to the timing ofcollections at the end of our reporting periods. Hiland Partners  collects and pays large receivables andpayables at the end of each calendar month. The timing of these payments andreceipts may vary by a day or two between month-end periods and causefluctuations in cash received or paid. Working capital items, exclusive ofcash, contributed $3.1 million of cash flows from operating activities duringthe six months ended June 30, 2008 and contributed $0.9 million to cashflows from operating activities during the six months ended June 30, 2007.Net loss for the six months ended June 30, 2008 was $0.3 million, adecrease of $2.2 million from a net income of $1.9 million for the six monthsended June 30, 2007.  Depreciation and amortization increased by $4.3million to $18.6 million for the six months ended June 30, 2008 from $14.3million for the six months ended June 30, 2007.  Bad debt expense was $8.1 million for the sixmonths ended June 30, 2008 compared to zero for the six months ended June 30,2007.

 

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

 

Cash flows used forinvesting activities, which represent investments in property and equipmentdecreased by $16.4 million to $20.3 million for the six months ended June 30,2008 from $36.7 million for the six months ended June 30, 2007predominately due to reduced capital investing in the six months ended June 30,2008 related to the Badlands nitrogen rejection plant which was underconstruction during the first six months of 2007.

 

***Cash Flows from Financing Activities***

 

Cash flows from financingactivities decreased to $1.4 million for the six months ended June 30,2008 from $16.9 million for the six months ended June 30, 2007, a decreaseof $15.5 million. During the six months ended June 30, 2008, HilandPartners borrowed $19.0 million under its credit facility to fund its internalexpansion projects and received capital contributions of $1.0 million as aresult of issuing Hiland Partners common units due to  the exercise of 40,705 vested unit options.During the six months ended June 30, 2008, Hiland Partners also incurreddebt issuance costs of $0.3 million associated with the fourth amendment to itscredit facility amended in February 2008 and made $0.2 million payments oncapital lease obligations. During the six months ended June 30, 2008, wemade distributions of $11.6 million to our unitholders and Hiland Partnersdistributed $6.4 million to its minority interest unitholders. During thesix months ended June 30, 2007, Hiland Partners borrowed $30.5 millionunder its credit facility to fund its internal expansion projects and weborrowed $0.1 million on our credit facility. During the six months ended June 30, 2007,Hiland Partners receivedcapital contributions of $1.0 million as a result of issuing Hiland Partnerscommon units due to the exercise of 42,362 vested unit options. During the sixmonths ended June 30, 2007, we made distributions of $9.0 million to ourunitholders, Hiland Partners distributed $2.8 million to its minorityinterest unitholders and Hiland Partners paid deferred offering costs of $0.1million associated with Hiland Partners’ S-3/A registration statement filedwith the SEC on January 23, 2007.

 

***Capital Requirements***

 

Hiland Partners’midstream energy business is capital intensive, requiring significantinvestment to maintain and upgrade existing operations. Hiland Partners’capital requirements have consisted primarily of, and we anticipate willcontinue to be:

 

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·         maintenancecapital expenditures, which are capital expenditures made to replace partiallyor fully depreciated assets to maintain the existing operating capacity ofHiland Partners’ assets and to extend their useful lives, or other capitalexpenditures that are incurred in maintaining existing system volumes andrelated cash flows; and

 

·         expansioncapital expenditures such as those to acquire additional assets to grow HilandPartners’ business, to expand and upgrade gathering systems, processing plants,treating facilities and fractionation facilities and to construct or acquiresimilar systems or facilities.

 

We believe that cashgenerated from the operations of Hiland Partners’ business will be sufficientto meet its anticipated maintenance capital expenditures for the next twelvemonths. Given Hiland Partners objective of growth through acquisitions andexpansions, Hiland Partners anticipates that it will continue to investsignificant amounts of capital to grow and acquire assets. Hiland Partners activelyconsiders a variety of assets for potential acquisitions. We anticipate thatits expansion capital expenditures will be funded through long-term borrowingsor other debt financings and/or equity offerings. See “Credit Facility” belowfor information related to our credit agreements.

 

***North Dakota Bakken***

 

Hiland Partners plans tomake an initial capital investment of approximately $10.0 million by the end of2008 with additional investments of up to $17.0 million over the next threeyears to build gas processing and treating facilities and install fieldgathering, compression and associated equipment at the Bakken Shale play innorthwestern North Dakota in which CLR has dedicated approximately 129,000gross acres to Hiland Partners. The expected startup of the initial phase ofthe project should occur no later than the second quarter of 2009.

 

***Woodford Shale***

 

Hiland Partners is continuing to expand the WoodfordShale gathering system located in the Woodford Shale reservoir area in theArkoma Basin of southeastern Oklahoma.The gathering system is being designed to provide low-pressure and highlyreliable gathering, compression and dehydration services. During the thirdquarter of 2008, the gathering infrastructure is expected to include up to17,400 horsepower of compression to provide takeaway capacity in excess of65,000 Mcf/d.  As of June 30, 2008,Hiland Partners has invested $29.4 million in this internal expansion project.

 

***FinancialDerivatives and Commodity Hedges.***

 

Hiland Partners hasentered into certain financial derivative instruments that are classified ascash flow hedges in accordance with SFAS 133 and relate to forecasted sales in2008 and 2009, and a non-qualifying mark-to-market cash flow hedge that relatesto forecasted sales in 2010. Hiland Partners entered into these instruments tohedge the forecasted natural gas and natural gas liquid sales or purchasesagainst the variability in expected future cash flows attributable to changesin market prices. The swap instruments are contractual agreements betweencounterparties to exchange obligations of money as the underlying natural gasor natural gas liquids are sold or purchased. Under these swap agreements,Hiland Partners either receives or pays a monthly net settlement that isdetermined by the difference between a fixed price and a floating price basedon certain indices for the relevant contract period for the agreed uponvolumes.

 

The following tableprovides information about these financial derivative instruments for theperiods indicated:

 
| ** **                                                                                | ** ** | ** **  | ** ** | **Average**          | ** ** | **Fair Value** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------|------------|----------------------|------------|---------------------|------------|
| ** **                                                                                | ** ** | ** **  | ** ** | **Fixed**            | ** ** | **Asset**           | ** ** |
| ** **                                                                                | ** ** | **Volume**  | ** ** | **Price**            | ** ** | **(Liability)**     | ** ** |
| **Description and Production Period**                                      | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **          | ** ** |
| Natural Gas - Sold Fixed for Floating Price Swaps | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| July 2008 -  June 2009                                                          |       | 2,058,000   |       | $                    | 7.56       |                | $          | (4,188 | ) |
| July 2009 -  December 2009                                                      |       | 1,068,000   |       | $                    | 7.30       |                | (533       | ) |
| January 2010  - December 2010                                                   |       | 2,136,000   |       | $                    | 10.50      |                | (1,512     | ) |
|                                                                                      |       |        |       |                 |       | $                   | (6,233     | ) |

 
| ** **                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-------------|------------|-----------------|------------|------------|------------|
| Natural Gas -  Buy Fixed for Floating Price Swaps |       |        |       |            |       |       |       |
| July 2008 -  December 2008              |       | 360,576     |       | $               | 6.93       |       | $          | 1,483 |   |
|                                                   |            |             |            |                 |            |            |            |  |  |

 
| ** **                                                 | ** ** | **(Bbls)** | ** ** | **(per Gallon)** | ** ** | ** ** | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| Natural Gas Liquids - Sold Fixed for Floating Price  Swaps | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** |
| July 2008 -  December 2008                       |       | 220,884    |       | $                | 1.31       |       | $          | (7,597 | ) |
|                                                            |            |            |            |                  |            |            |            |  |  |

 

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In addition to thederivative instruments noted in the table above, Hiland Partners has executedone natural gas fixed price physical forward sales contract on 100,000 MMBtuper month with a fixed price of $8.43 per MMBtu for the remainder of2008.  This contract has been designated as normal sales under SFAS 133and is therefore not marked to market as a derivative.

 

***Off-BalanceSheet Arrangements.***

 

We had no significantoff-balance sheet arrangements as of June 30, 2008.

 

***Credit Facility***

 

***Hiland Holdings***

 

On September 25,2006, concurrently with the closing of our initial public offering, we enteredinto a three-year $25.0 million secured revolving credit facility. Thecredit facility permits us, if certain conditions are met, to increaseborrowing capacity by up to an additional $25.0 million. The credit facilitywill be secured by all of our ownership interests in Hiland Partners and itsgeneral partner, other than the 2% general partner interest and the incentivedistribution rights.

 

The credit facility willmature on September 25, 2009, at which time all outstanding amountsthereunder become due and payable.

 

Indebtedness under thecredit facility will bear interest, at our option, at either (i) analternate base rate plus an applicable margin ranging from 100 to 150 basispoints per annum or (ii) LIBOR plus an applicable margin ranging from 200to 250 basis points per annum in each case based on our ratio of consolidatedfunded debt to EBITDA. The alternate base rate is equal to the greatest of (a) theprime rate in effect on such day, (b) the base CD rate in effect on suchday plus 1.50% and (c) the federal funds effective rate in effect on suchday plus 1/2 of 1%. A letter of credit fee will be payable for the aggregateamount of letters of credit issued under the credit facility at a percentageper annum equal to 2.0%. A commitment fee ranging from 25 to 50 basis pointsper annum based on our ratio of consolidated funded debt to EBITDA will bepayable on the average daily unused portion of the credit facility for thequarter most recently ended. At June 30, 2008, the interest rate onoutstanding borrowings from our credit facility was 4.48%.

 

The credit facilitycontains several covenants that, among other things, require the maintenance oftwo financial performance ratios, restrict the payment of distributions tounitholders, and require financial reports to be submitted periodically to thefinancial institutions.

 

The credit facility alsocontains covenants requiring a maximum consolidated funded debt to EBITDA ratioof 3.0:1.0 for the four fiscal quarters most recently ended and a minimuminterest coverage ratio of 3.0:1.0.

 

The amount we may borrowunder the credit facility is limited to the lesser of: (i) 50% of the sumof the value of the Hiland Partners common and subordinated units and certainother assets held by us and certain of our subsidiaries at the end of eachfiscal quarter and (ii) the maximum available amount of the creditfacility (currently $25.0 million). For purposes of this calculation, the valueof (i) the Hiland Partners common units on any date shall be the closingprice for such units as reflected on the Nasdaq National Market on any date,and (ii) the Hiland Partners subordinated units on any date shall bedeemed to equal 85% of the value of the Hiland Partners common units on suchdate.

 

The credit facilityprohibits us from making distributions to unitholders if any default or eventof default, as defined in the credit facility, has occurred and is continuingor would result from the distribution. In addition, the credit facilitycontains various covenants that limit, among other things, subject to certainexceptions and negotiated “baskets,” our ability to incur indebtedness, grantliens, enter into agreements restricting our ability to grant liens on ourassets or amend the credit facility, make certain loans, acquisitions andinvestments or enter into a merger, consolidation or sale of assets.

 

The credit facilitylimits distributions to our unitholders to our available cash, as defined inour partnership agreement. Restricted payments under the credit facility aresubject to an annual “clean-down” period of 15 consecutive days in which theamount outstanding that relates to funding the restricted payments under thecredit facility must be reduced to zero.

 

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As of June 30, 2008,we had $0.4 million outstanding under this credit facility and were incompliance with our financial covenants.

 

***Hiland Partners***

 

On February 6, 2008,Hiland Partners entered into a fourth amendment to its credit facility dated February 15,2005. Pursuant to the fourth amendment, Hiland Partners has, among otherthings, increased its borrowing base from $250 million to $300 million anddecreased the accordion feature in the facility from $100 million to $50million.   Hiland Partners’ originalcredit facility dated February 15, 2005 was first amended in September 2005,amended a second time in June 2006 and amended a third time in July 2007.

 

The fourth amendmentincreases Hiland Partners’ borrowing capacity under its senior securedrevolving credit facility to $300 million such that the facility now consistsof a $291 million senior secured revolving credit facility to be used forfunding acquisitions and other capital expenditures, issuance of letters ofcredit and general corporate purposes (the “Acquisition Facility”) and a $9.0million senior secured revolving credit facility to be used for working capitaland to fund distributions (the “Working Capital Facility”).

 

In addition, the fourthamendment provides for an accordion feature, which permits Hiland Partners, ifcertain conditions are met, to increase the size of the Acquisition Facility byup to $50 million and allows for the issuance of letters of credit of up to $15million in the aggregate.  The senior secured revolving credit facilityalso requires Hiland Partners to meet certain financial tests, including amaximum consolidated funded debt to EBITDA ratio of 4.0:1.0 as of the last dayof any fiscal quarter; provided that in the event that the Partnership makescertain permitted acquisitions or capital expenditures, this ratio may beincreased to 4.75:1.0 for the three fiscal quarters following the quarter inwhich such acquisition or capital expenditure occurs; and a minimum interestcoverage ratio of 3.0:1.0. The credit facility will mature in May 2011. Atthat time, the agreement will terminate and all outstanding amounts thereunderwill be due and payable.

 

Hiland Partners’obligations under the credit facility are secured by substantially all ofHiland Partners’ assets and guaranteed by Hiland Partners, and all of HilandPartners’ subsidiaries, other than Hiland Partners’ operating company, which isthe borrower under the credit facility.

 

Indebtedness under thecredit facility will bear interest, at Hiland Partners’ option, at either (i) anAlternate Base Rate, as defined therin, plus an applicable margin ranging from50 to 125 basis points per annum or (ii) LIBOR plus an applicable marginranging from 150 to 225 basis points per annum based on Hiland Partners’ ratioof consolidated funded 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) thebase CD rate in effect on such day plus 1.50% and (c) the Federal Fundseffective rate in effect on such day plus 1/2 of 1%. A letter of credit fee will bepayable for the aggregate amount of letters of credit issued under the creditfacility at a percentage per annum equal to 1.0%. An unused commitment feeranging from 25 to 50 basis points per annum based on Hiland Partners’ ratio ofconsolidated funded debt to EBITDA will be payable on the unused portion of thecredit facility. During any step-up period, the applicable margin with respectto loans under the credit facility will be increased by 35 basis points perannum and the unused commitment fee will be increased by 12.5 basis points perannum. At June 30, 2008, the interest rate on outstanding borrowings fromHiland Partners’ credit facility was 4.78%

 

The credit facilityprohibits Hiland Partners from making distributions to unitholders if anydefault or event of default, as defined in the credit facility, has occurredand is continuing or would result from the distribution. In addition, thecredit facility contains various covenants that limit, among other things, subjectto certain exceptions and negotiated “baskets,” Hiland Partners’ ability toincur indebtedness, grant liens, make certain loans, acquisitions andinvestments, make any material changes to the nature of its business, amend itsmaterial agreements, including the Omnibus Agreement or enter into a merger,consolidation or sale of assets.

 

The credit facilitydefines EBITDA as Hiland Partners’ consolidated net income, plus income taxexpense, interest expense, depreciation, amortization and accretion expense,amortization of intangibles and organizational costs, non-cash unit basedcompensation expense, and adjustments for non-cash gains and losses onspecified derivative transactions and for other extraordinary or non-recurringitems.

 

Upon the occurrence of anevent of default as defined in the credit facility, the lenders may, amongother things, be able to accelerate the maturity of the credit facility andexercise other rights and remedies as set forth in the credit facility.

 

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The credit facilitylimits distributions to Hiland Partners’ unitholders to available cash, asdefined by the agreement, and borrowings to fund such distributions are onlypermitted under the revolving working capital facility. The revolving workingcapital facility is subject to an annual “clean-down” period of 15 consecutivedays in which the amount outstanding under the revolving working capitalfacility is reduced to zero.

 

As of June 30, 2008,Hiland Partners had $240.1 million outstanding under its credit facilityand was in compliance with its financial covenants.

 

***Impactof Inflation***

 

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

 

**Recent Accounting Pronouncements**

 

On March 19, 2008,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities”, an amendment of SFAS 133(“SFAS 161”). SFAS 161 is intended to improve transparency in financialreporting by requiring enhanced disclosures of an entity’s derivativeinstruments and hedging activities and their effects on the entity’s financialposition, financial performance, and cash flows. SFAS 161 is effectiveprospectively for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008, with early applicationencouraged. SFAS 161 encourages, but does not require, comparative disclosuresfor periods prior to its initial adoption. SFAS 161 amends the currentqualitative and quantitative disclosure requirements for derivative instrumentsand hedging activities set forth in SFAS 133 and generally increases the levelof aggregation/disaggregation that will be required in an entity’s financialstatements. We are currently reviewing SFAS 161 to determine the effect it willhave on our financial statements and disclosures therein.

 

On March 12, 2008,the Emerging Issues Task Force (“EITF”) reached consensus opinion on EITF Issue07-4, “Application of the two-class method under FASB Statement No. 128,Earnings per Share, to Master Limited Partnerships” (“EITF 07-4”), which theFASB ratified at its March 26, 2008 meeting. EITF 07-4 requires thecalculation of a Master Limited Partnership’s (“MLPs”) net earnings per limitedpartner unit for each period presented according to distributions declared andparticipation rights in undistributed earnings as if all of the earnings forthat period had been distributed. In periods with undistributed earnings abovespecified levels, the calculation per the two-class method results in anincreased allocation of such undistributed earnings to the general partner anda dilution of earnings to the limited partners. EITF 07-4 is effective forfiscal years beginning after December 15, 2008, and is to be appliedretrospectively to all periods presented. Early application is not permitted.We will apply the requirements of EITF 07-4 as it pertains to MLPs upon itsadoption during the quarter ended March 31, 2009.

 

In December 2007,FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”). SFAS141(R) amends and replaces SFAS 141, but retains the fundamental requirementsin SFAS 141 that the purchase method of accounting be used for all businesscombinations and an acquirer be identified for each business combination. SFAS141(R) provides for how the acquirer recognizes and measures theidentifiable assets acquired, liabilities assumed and any non-controllinginterest in the acquiree. SFAS 141(R) provides for how the acquirerrecognizes and measures the goodwill acquired in the business combination or again from a bargain purchase. SFAS 141(R) also determines what informationto disclose to enable users to be able to evaluate the nature and financialeffects of the business combination. The provisions of SFAS 141(R) applyprospectively to business combinations for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008 and do not allow early adoption. We are evaluating the new requirements ofSFAS 141(R) and the impact it will have on business combinations completedin 2009 and thereafter.

 

In December 2007,the FASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements – an amendment of ARB No. 51” (“SFAS 160”).” SFAS 160establishes accounting and reporting standards that require the ownershipinterests in subsidiaries held by parties other than the parent (minorityinterest) be clearly identified, labeled, and presented in the consolidatedbalance sheet within equity, but separate from the parent’s equity. SFAS 160requires the equity amount of consolidated net income attributable to theparent and to the noncontrolling interest be clearly identified and presentedon the face of the consolidated income statement and that changes in a parent’sownership interest while the parent retains its controlling financial interestin its subsidiary be accounted for consistently and similarly as equitytransactions. Consolidated net income and comprehensive income will bedetermined without deducting minority interest; however, earnings-per-shareinformation will continue to be calculated on the basis of the net incomeattributable to the parent’s shareholders. Additionally, SFAS 160 establishes asingle method for accounting for changes in a parent’s ownership interest

 

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in a subsidiary that does not result in deconsolidation and that theparent recognize a gain or loss in net income when a subsidiary isdeconsolidated. SFAS 160 is effective for fiscal years beginning on or after December 15,2008. Early adoption is not permitted. We do not expect SFAS 160 will have amaterial impact on our financial position, results of operations or cash flows.

 

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities.” (“SFAS 159”). SFAS 159 expands opportunities to usefair value measurement in financial reporting and permits entities to choose tomeasure many financial instruments and certain other items at fair value. SFAS159 is effective for fiscal years beginning after November 15, 2007. SFAS159 was adopted by us effective January 1, 2008, at which time nofinancial assets or liabilities, not previously required to be recorded at fairvalue by other authoritative literature, were designated to be recorded at fairvalue. As such, the adoption of SFAS 159 did not have any impact on ourfinancial position, results of operations or cash flows.

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS157 defines fair value as the price that would be received to sell an asset orpaid to transfer a liability in an orderly transaction between marketparticipants at the measurement date, establishes a framework for measuringfair value in generally accepted accounting principles (GAAP) such as fairvalue hierarchy used to classify the source of information used in fair valuemeasurements (i.e., market based or non-market based) and expands disclosureabout fair value measurements based on their level in the hierarchy.  SFAS 157 applies to derivatives and otherfinancial instruments, which SFAS 133 requires be measured at fair value atinitial recognition and for all subsequent periods. SFAS 157 establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.SFAS 157’s hierarchy defines three levels of inputs that may be used to measurefair value. Level 1 refers to assets that have observable market prices, level2 assets do not have an “observable price” but do have inputs that are based onsuch prices in which components have observable data points and level 3 refersto assets in which one or more of the inputs do not have observable prices andcalibrated model parameters, valuation techniques or management’s assumptionsare used to derive the fair value. SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. We elected to implement SFAS 157prospectively in the first quarter of 2008 with the one-year deferral permittedby FASB Staff Position (FSP) 157-2 for nonfinancial assets andnonfinancial liabilities measured at fair value, except those that arerecognized or disclosed on a recurring basis (at least annually). The deferralapplies to nonfinancial assets and liabilities measured at fair value in abusiness combination; impaired properties, plants and equipment; intangibleassets and goodwill; and initial recognition of asset retirement obligationsand restructuring costs for which we use fair value. We do not expect anysignificant impact to our consolidated financial statements when we implementSFAS 157 for these assets and liabilities.

 

**Significant Accounting Policies and Estimates**

 

*RevenueRecognition.  *Revenues for sales of natural gas and NGLs product sales are recognized at thetime the product is delivered and title is transferred. Revenues for compressionservices are recognized when the services under the agreement are performed.

 

*Depreciationand Amortization**.**  *Depreciation of all equipment is determined under the straight-line methodusing various rates based on useful lives, 10 to 22 years for pipeline andprocessing plants, and 3 to 10 years for corporate and other assets. Thecost of assets and related accumulated depreciation is removed from theaccounts when such assets are disposed of, and any related gains or losses arereflected in current earnings. Maintenance, repairs and minor replacements areexpensed as incurred. Costs of replacements constituting improvement arecapitalized. Intangible assets consist of the acquired value of existingcontracts to sell natural gas and other NGLs, compression contracts andidentifiable customer relationships, which do not have significant residualvalue. The contracts are being amortized over their estimated lives of tenyears.

 

*Derivatives.  *We utilize derivative financial instruments to reduce commodity price risks. Wedo not hold or issue derivative financial instruments for trading purposes.Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments andHedging Activities”, which was amended in June 2000 by SFAS 138 and in May 2003by SFAS 149, establishes accounting and reporting standards for derivativeinstruments and hedging activities. It requires that an entity recognize allderivatives as either assets or liabilities in the statement of financial conditionand measure those instruments at fair value. Derivatives that are notdesignated as hedges are adjusted to fair value through income. If thederivative is designated as a hedge, depending upon the nature of the hedge,changes in the fair value of the derivatives are either offset against the fairvalue of assets, liabilities or firm commitments through income, or recognizedin

 

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other comprehensive income until the hedged item is recognized inincome. The ineffective portion of a derivative’s change in fair value isimmediately recognized into income. If a derivative no longer qualifies forhedge accounting the amounts in accumulated other comprehensive income will beimmediately charged to operations.

 

*Asset Retirement Obligations.*  SFAS No. 143, “Accounting forAsset Retirement Obligations”, requires entities to record the fair value of aliability for an asset retirement obligation in the period in which it isincurred and a corresponding increase in the carrying amount of the relatedlong-lived asset. Subsequently, the asset retirement cost is allocated toexpense using a systematic and rational method and the liability is accreted tomeasure the change in liability due to the passage of time. The primary impactof SFAS 143 relates to our estimated costs for dismantling and site restorationof certain of our plants and pipelines. Estimating future asset retirementobligations requires us to make estimates and judgments regarding timing,existence of a liability, as well as what constitutes adequate restoration. Weuse the present value of estimated cash flows related to our asset retirementobligation to determine the fair value, generally as estimated by third partyconsultants. The present value calculation requires us to make numerousassumptions and judgments, including the ultimate costs of dismantling and siterestoration, inflation factors, credit adjusted discount rates, timing ofsettlement and changes in the legal, regulatory, environmental and politicalenvironments. To the extent future revisions to these assumptions impact thepresent value of the existing asset retirement obligation liability, a correspondingadjustment will be required to the related asset. We believe the estimates andjudgments reflected in our financial statements are reasonable but arenecessarily subject to the uncertainties we have just described. Accordingly,any significant variance in any of the above assumptions or factors couldmaterially affect our cash flows.

 

*Impairment of Long-Lived Assets.*  In accordance with Statement SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluateour long-lived assets, including intangible assets, of identifiable businessactivities for impairment when events or changes in circumstances indicate, inmanagement’s judgment, that the carrying value of such assets may not berecoverable. The determination of whether impairment has occurred is based onmanagement’s estimate of undiscounted future cash flows attributable to theassets as compared to the carrying value of the assets. If impairment hasoccurred, the amount of the impairment recognized is determined by estimatingthe fair value for the assets and recording a provision for loss if thecarrying value is greater than fair value. For assets identified to be disposedof in the future, the carrying value of these assets is compared to theestimated fair value less the cost to sell to determine if impairment isrequired. Until the assets are disposed of, an estimate of the fair value isre-determined when related events or circumstances change.

 

Whendetermining whether impairment of one of our long-lived assets has occurred, wemust estimate the undiscounted cash flows attributable to the asset or assetgroup. Our estimate of cash flows is based on assumptions regarding the volumeof reserves providing asset cash flow and future NGL product and natural gas prices.The amount of reserves and drilling activity are dependent in part on naturalgas prices. Projections of reserves and future commodity prices are inherentlysubjective and contingent upon a number of variable factors, including, but notlimited to:

 

·* *changes in general economic conditions inregions in which the Partnership’s products are located;

·* *the availability and prices of NGL productsand competing commodities;

·* *the availability and prices of raw natural gassupply;

·* *our ability to negotiate favorable marketingagreements;

·* *the risks that third party oil and gasexploration and production activities will not occur or be successful;

·* *our dependence on certain significantcustomers and producers of natural gas; and

·* *competition from other midstream serviceproviders and processors, including major energy companies.

 

Anysignificant variance in any of the above assumptions or factors couldmaterially affect our cash flows, which could require us to record animpairment of an asset.

 

*ShareBased Compensation.*  InOctober 1995 the FASB issued SFAS No. 123, “Share-Based Payment,”which was revised in December 2004 (“SFAS 123R”).  SFAS 123R requires that the compensation costrelating to share-based payment transactions be recognized in the financialstatements and that cost be measured based on the fair value of the equity orliability instruments issued.

 

We estimate the fairvalue of each unit option granted on the date of grant using the AmericanBinomial option-pricing model. In estimating the fair value of each option, weuse our peer group volatility averages as determined on the option grant dates. We calculate expected lives of the options under the simplified method asprescribed by the SEC Staff Accounting Bulletin 107 and have used a risk freeinterest rate based on the applicable U.S. Treasury yield in effect at the

 

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time of grant. We estimate the fair value of each restricted unitgranted on the date of grant based on the unit closing price on that samedate.  Our compensation expense for these awards is recognized onthe graded vesting attribution method. Units to be issued under our unitincentive plan may be from newly issued units.

 

**Item 3.  Quantitative and Qualitative Disclosuresabout Market Risk**

 

Market risk is the riskof loss arising from adverse changes in market rates and prices. The principalmarket risk to which Hiland Partners is exposed is commodity price risk fornatural gas and NGLs. Hiland Partners also incurs, to a lesser extent, risksrelated to interest rate fluctuations. Hiland Partners does not engage incommodity energy trading activities.

 

***Commodity Price Risks.  ***Hiland Partners profitability is affected by volatility in prevailing NGL andnatural gas prices. Historically, changes in the prices of most NGL productshave generally 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. Hiland Partnerscash flow is affected by the volatility of natural gas and NGL product prices,which could adversely affect our ability to make distributions to unitholders.To illustrate the impact of changes in prices for natural gas and NGLs on ouroperating results, we have provided the table below, which reflects, for thethree months ended June 30, 2008, the impact on our midstream segmentmargin of a $0.01 per gallon change (increase or decrease) in NGL pricescoupled with a $0.10 per MMBtu change (increase or decrease) in the price ofnatural gas. The magnitude of the impact on total segment margin of changes innatural gas and NGL prices presented may not be representative of the magnitudeof the impact on total segment margin for different commodity prices orcontract portfolios. Natural gas prices can also affect our profitabilityindirectly by influencing the level of drilling activity and relatedopportunities for our services.

 
| ** **          | ** ** | ** ** | ** ** | **Natural Gas Price Change ($/MMBtu)** | ** ** |
|---------------------|------------|------------|------------|------------------------------------------------------------|------------|
|                |       |       |       | $                                                          | 0.10       |   | $ | (0.10 | ) |
| **NGL  Price**      |       | $          | 0.01       |                                                       | $          | 151,000 |   | $ | 142,000 |   |
| **Change  ($/gal)** |       | $          | (0.01      | )                                                          | $          | (127,000 | ) | $ | (189,000 | ) |

 

We manage this commodityprice exposure 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 2008, 2009 and 2010. 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:

 
| ** **                                           | ** ** | ** **  | ** ** | **Average**          | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------|------------|-------------|------------|----------------------|------------|---------------------|------------|
| ** **                                           | ** ** | ** **  | ** ** | **Fixed**            | ** ** | **Asset**           | ** ** |
| **Description and Production Period** | ** ** | **Volume**  | ** ** | **Price**            | ** ** | **(Liability)**     | ** ** |
| ** **                                           | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **          | ** ** |
| Natural Gas -  Sold Fixed for Floating Price Swaps   |       |        |       |                 |       |                |       |
| July 2008 -  June 2009                     |       | 2,058,000   |       | $                    | 7.56       |                | $          | (4,188 | ) |
| July 2009 -  December 2009                 |       | 1,068,000   |       | $                    | 7.30       |                | (533       | ) |
| January 2010  - December 2010              |       | 2,136,000   |       | $                    | 10.50      |                | (1,512     | ) |
|                                                 |       |        |       |                 |       | $                   | (6,233     | ) |

 
| ** **                                                                               | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------|------------|----------------------|------------|------------|------------|
| Natural Gas - Buy Fixed for Floating Price Swaps |       |        |       |                 |       |       |       |
| July 2008 -  December 2008                                                     |       | 360,576     |       | $                    | 6.93       |       | $          | 1,483 |   |
|                                                                                          |            |             |            |                      |            |            |            |  |  |

 
| ** **                                                 | ** ** | **(Bbls)** | ** ** | **(per Gallon)** | ** ** | ** ** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-----------------------|------------|------------|------------|
| Natural Gas  Liquids - Sold Fixed for Floating Price Swaps |       |       |       |                  |       |       |       |
| July 2008 -  December 2008                       |       | 220,884    |       | $                     | 1.31       |       | $          | (7,597 | ) |
|                                                            |            |            |            |                       |            |            |            |  |  |

 

In addition to thederivative instruments noted in the table above, Hiland Partners has executedone natural gas fixed price physical forward sales contract on 100,000 MMBtuper month with a fixed price of $8.43 per MMBtu for the remainder of2008.  This contract has been designated as normal sales under SFAS No. 133and is therefore not marked to market as a derivative.

 

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***Interest Rate Risk.***   We areexposed to changes in interest rates as a result of our credit facility andHiland Partners’ credit facility, which have floating interest rates. Asof June 30, 2008 we had approximately $0.4 million of indebtednessoutstanding under our credit facility which was used to finance the costsrelated to the closing of our $25.0 million secured revolving creditfacility. As of June 30, 2008, Hiland Partners had approximately $240.1million of indebtedness outstanding under its credit facility. The impact of a100 basis point increase in interest rates on the amount of current debt wouldresult in an increase in interest expense and a corresponding decrease in netincome of approximately $2.4 million annually.

 

***Credit Risk.****  * Counterparties pursuant to the terms of theircontractual obligations expose Hiland Partners to potential losses as a resultof nonperformance. Hiland Partners’ five largest customers for the three monthsended June 30, 2008 accounting for approximately 22%, 15%, 14%, 10% and9%, respectively, of revenues. Consequently, changes within one or more ofthese companies’ operations have the potential to impact, both positively andnegatively, our credit exposure. Hiland Partners’ counterparties for Hiland Partners’ derivative instruments as of June 30, 2008 are BP Energy Company and Bank of Oklahoma,N.A.

 

On July 22, 2008, SemGroup, L.P. and certainsubsidiaries filed voluntary petitions for reorganization under Chapter 11 ofthe U.S. Bankruptcy Code.  Affiliates ofSemGroup, L.P. purchase Hiland Partners’ natural gas liquids and condensate,primarily at its Bakken and Badlands plants and gathering systems.  As a result, Hiland Partners has increasedits allowance for doubtful accounts and bad debt expense by approximately $8.1million in the three and six month periods ended June 30, 2008.  Hiland Partners estimates additionalpotential exposure of approximately $5.0 million with this purchaser foruninvoiced product sales from July 1 through July 18, 2008.  Hiland Partners has made temporaryarrangements with other third parties for Hiland Partners’ product sales whileassessing its options in light of SemGroup’s bankruptcy.  Hiland Partners is monitoring the bankruptcycases closely to pursue the best course of action to obtain payment of theamounts owed to them and to continue natural gas liquids and condensate salesat Hiland Partners’ Bakken and Badlands plants and gathering systems.  This matter is not expected to cause HilandPartners to be out of compliance with its covenants under its credit facilityor impact Hiland Partners’ liquidity position in any material respect.

 

**Item4.  Controls and Procedures**

 

**Evaluation of Disclosure Controls and Procedures**

 

(a) Evaluation ofdisclosure controls and procedures.

 

As required by Rule 13a-15(b) under the SecuritiesExchange Act of 1934, as amended, we have evaluated, under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act) as of the end of the period covered bythis Quarterly Report on Form 10-Q. Based upon that evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures were effective as of June 30, 2008, toensure that information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure and isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the SEC.

 

(b) Changes ininternal control over financial reporting.

 

During the three months ended June 30, 2008,there were no changes in our system of internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**PART IIOTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

Although there are nosignificant regulatory proceedings in which we are currently involved,periodically we may be a party to regulatory proceedings. The results ofregulatory proceedings cannot be predicted with certainty; however, ourmanagement believes that we presently do not have material potential liabilityin connection with regulatory proceedings that would have a significant financialimpact on our consolidated financial condition, results of operations or cashflows.

 

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**Item 1A.Risk Factors**

 

In addition to the otherinformation set forth in this report, you should carefully consider the factorsdiscussed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2007, which could materially affect ourbusiness, financial condition or future results. The risks described in ourAnnual Report on Form 10-K are not the only risks facing our Company.Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/ or operating results.

 

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None.

 

**Item 3. Defaults Upon SeniorSecurities**

 

None.

 

**Item 4. Submission of Matters to a Voteof Security Holders**

 

None.

 

**Item 5. Other Information**

 

None.

 

**Item 6.Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                         |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 | —     | Certificate of Limited  Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Registration Statement on Form S-1  (File No. 333-134491)).                                |
| 3.2                 | —     | Amended and Restated  Agreement of Limited Partnership of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 3.2 of Registrant’s Registration Statement on  Form S-1 (File No. 333-134491)).             |
| 3.3                 | —     | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                  |
| 3.4                 | —     | Form of Amended  and Restated Limited Liability Company Agreement of Hiland Partners GP Holdings, LLC(incorporated  by reference to Exhibit 3.4 of Registrant’s Statement on form S-1. (File  No. 333-134491)) |
| 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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**SIG**N**ATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized in the city of Enid, Oklahoma, onthe 11th day of August, 2008.

 
|            | **HILAND HOLDINGS GP, LP** |
|------------|----------------------------|
| ** ** | **By:**                    | **Hiland Partners GP Holdings, LLC, its general  partner** |
|       | By:                        | /s/ Joseph L. Griffin |
|       |                       | Joseph L. Griffin |
|       | * *                   | *Chief Executive Officer, President and Director* |
|       |                       |   |
|       |                       |   |
|       | By:                        | /s/ Matthew S. Harrison |
|       |                       | Matthew S. Harrison |
|       | * *                   | *Chief Financial Officer, Vice President-Finance,  Secretary  and Director* |

 

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**Exhibit Index**

 
| **Exhibit********Number** | ** ** | **Description**                                                                                                                                                                                                                         |
|---------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                       | —     | Certificate of Limited  Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                  |
| 3.2                       | —     | Amended and Restated  Agreement of Limited Partnership of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 3.2 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                               |
| 3.3                       | —     | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                  |
| 3.4                       | —     | Form of Amended  and Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.4 of  Registrant’s Statement on form S-1. (File No. 333-134491)) |
| 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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