**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **x****  QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                  |
|-------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                |
| **FOR  THE QUARTERLY PERIOD ENDED September 30, 2007**                                                                                    |
| ** **                                                                                                                                |
| **OR**                                                                                                                                    |
| ** **                                                                                                                                |
| **o****  TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                 |
| ** **                                                                                                                                |
| **FOR  THE TRANSITION PERIOD FROM          TO          ** |
| ** **                                                                                                                                |
| **Commission  file number:  000-51120**                                                                                              |

 

**HilandHoldings GP, LP**

(Exact name of Registrantas 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)          |

 

Registrant’s telephone numberincluding area code**  (580) 242-6040**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x    No o

 

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

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

 

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

 

The number of theregistrant’s outstanding equity units at November 2, 2007 was 21,603,000 commonunits.

 

 

----

 

**HILANDHOLDINGSGP, LP**

 

**INDEX**

 
| **PART  I. FINANCIAL INFORMATION**                                                                  | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|
| Item 1. Financial  Statements (Unaudited, except December 31, 2006 Balance Sheet)                   |       |
| Consolidated  Balance Sheets                                                                        |       |
| Consolidated  Statements of Operations                                                              |       |
| Consolidated  Statements of Cash Flows                                                              |       |
| Consolidated  Statement of Changes in Owners’ Equity and Comprehensive Income                  |       |
| Condensed Notes to Consolidated Financial Statements                                                |       |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |       |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risks                                |       |
| Item 4. Controls and Procedures                                                                     |       |
| **PART  II. OTHER INFORMATION**                                                                     |       |
| Item  1. Legal Proceedings                                                                          |       |
| Item  1A. Risk Factors                                                                              |       |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                |       |
| Item 3. Defaults Upon Senior Securities                                                             |       |
| Item 4. Submission of Matters to a Vote of Security  Holders                                        |       |
| Item  5. Other Information                                                                          |       |
| Item 6.  Exhibits                                                                                   |       |
| SIGNATURES                                                                                          |       |
| Certification of CEO  under Section 302                                                             |       |
| Certification of CFO  under Section 302                                                             |       |
| Certification of CEO  under Section 906                                                             |       |
| Certification of CFO  under Section 906                                                             |       |

 

2

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**HILANDHOLDINGS GP, LP**

 

**Consolidated Balance Sheets**

 
| ** **                                                    | ** ** | **September 30,**                                      | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2007**                                                    | ** ** | **2006**              | ** ** |
| ** **                                                    | ** ** | **(unaudited)**                                             | ** ** | ** **            | ** ** |
| ** **                                                    | ** ** | **(in thousands, except unit amounts)** | ** ** |
| **ASSETS**                                                    | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| **Current  assets:**                                          | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| Cash and cash  equivalents                                    |       | $                                                           | 8,928      |                  | $          | 10,569 |   |
| Accounts  receivable:                                         |       |                                                        |       |                  |       |
| Trade                                                         |       | 23,213                                                      |       | 23,702                |       |
| Affiliates                                                    |       | 905                                                         |       | 1,284                 |       |
|                                                          |       | 24,118                                                      |       | 24,986                |       |
| Fair value of  derivative assets                              |       | 4,144                                                       |       | 4,707                 |       |
| Other current  assets                                         |       | 861                                                         |       | 945                   |       |
| Total current  assets                                         |       | 38,051                                                      |       | 41,207                |       |
|                                                          |       |                                                        |       |                  |       |
| Property and  equipment, net                                  |       | 313,093                                                     |       | 257,003               |       |
| Intangibles, net                                              |       | 48,477                                                      |       | 53,094                |       |
| Fair value of  derivative assets                              |       | 1,177                                                       |       | 1,955                 |       |
| Other assets,  net                                            |       | 2,233                                                       |       | 1,939                 |       |
| **Total  assets**                                             |       | $                                                           | 403,031    |                  | $          | 355,198 |   |
|                                                          |       |                                                        |       |                  |       |
| **LIABILITIES  AND OWNERS’ EQUITY**                      | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| **Current  liabilities:**                                     | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| Accounts payable                                              |       | $                                                           | 22,115     |                  | $          | 19,161 |   |
| Accounts  payable—affiliates                             |       | 5,087                                                       |       | 4,412                 |       |
| Fair value of  derivative liabilities                         |       | 3,660                                                       |       | 1,902                 |       |
| Accrued  liabilities and other                                |       | 2,259                                                       |       | 1,459                 |       |
| Total current  liabilities                                    |       | 33,121                                                      |       | 26,934                |       |
|                                                          |       |                                                        |       |                  |       |
| Commitments and  contingencies (Note 7)                       |       |                                                        |       |                  |       |
| Long-term debt                                                |       | 206,608                                                     |       | 147,318               |       |
| Fair value of  derivative liabilities                         |       | 347                                                         |       | 291                   |       |
| Asset retirement  obligation                                  |       | 2,573                                                       |       | 2,196                 |       |
| Minority  interests                                           |       | 131,036                                                     |       | 137,302               |       |
|                                                          |       |                                                        |       |                  |       |
| **Owners’  equity**                                      | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| Common  unitholders (21,603,000 units issued and outstanding) |       | 28,933                                                      |       | 38,590                |       |
| Accumulated  other comprehensive income                       |       | 413                                                         |       | 2,567                 |       |
| **Total  owners’ equity**                                |       | 29,346                                                      |       | 41,157                |       |
|                                                          |       |                                                        |       |                  |       |
| **Total  liabilities and owners’ equity**                |       | $                                                           | 403,031    |                  | $          | 355,198 |   |

 

 Theaccompanying notes are an integral part of these consolidated financialstatements.

 

3

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**HILANDHOLDINGS GP, LP**

 

**Consolidated Statements of Operations**

 

**For theThree and Nine Months Ended (Unaudited)**

 
| ** **                                                                  | ** ** | **Three Months Ended**                                     | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                  | ** ** | **September 30,**                                               | ** ** | **September 30,**          | ** ** |
| ** **                                                                  | ** ** | **2007**                                                             | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                                  | ** ** | ** **                                                           | ** ** | **Predecessor**                 | ** ** | ** ** | ** ** | **Predecessor** | ** ** |
| ** **                                                                  | ** ** | **(in thousands, except per unit amounts)** | ** ** |
| **Revenues:**                                                               | ** ** | ** **                                                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream  operations                                                       |       |                                                                 |       |                            |       |   |   |   |   |
| Third parties                                                               |       | $                                                                    | 65,777     |                            | $          | 55,137 |   | $ | 189,301 |   | $ | 156,606 |   |
| Affiliates                                                                  |       | 654                                                                  |       | 925                             |       | 2,390 |   | 3,194 |   |
| Compression  services, affiliate                                            |       | 1,205                                                                |       | 1,205                           |       | 3,615 |   | 3,615 |   |
| Total revenues                                                              |       | 67,636                                                               |       | 57,267                          |       | 195,306 |   | 163,415 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Operating  costs and expenses:**                                          | ** ** | ** **                                                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream  purchases (exclusive of items shown separately below)            |       | 31,267                                                               |       | 26,480                          |       | 98,056 |   | 78,389 |   |
| Midstream  purchases -affiliate (exclusive of items shown separately below) |       | 14,522                                                               |       | 13,129                          |       | 39,264 |   | 39,576 |   |
| Operations and  maintenance                                                 |       | 6,157                                                                |       | 4,569                           |       | 16,108 |   | 11,140 |   |
| Depreciation,  amortization and accretion                                   |       | 7,870                                                                |       | 6,462                           |       | 22,222 |   | 16,256 |   |
| General and  administrative expenses                                        |       | 2,054                                                                |       | 1,397                           |       | 6,383 |   | 3,695 |   |
| Total operating  costs and expenses                                         |       | 61,870                                                               |       | 52,037                          |       | 182,033 |   | 149,056 |   |
| Operating income                                                            |       | 5,766                                                                |       | 5,230                           |       | 13,273 |   | 14,359 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Other  income (expense):**                                                | ** ** | ** **                                                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and  other income                                                  |       | 105                                                                  |       | 68                              |       | 325 |   | 221 |   |
| Amortization of  deferred loan costs                                        |       | (136                                                                 | )          | (170                            | )          | (357 | ) | (402 | ) |
| Interest expense                                                            |       | (3,133                                                               | )          | (2,387                          | )          | (7,538 | ) | (4,649 | ) |
| Other income  (expense), net                                                |       | (3,164                                                               | )          | (2,489                          | )          | (7,570 | ) | (4,830 | ) |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Income  before minority interest in income of Hiland Partners, LP**       |       | 2,602                                                                |       | 2,741                           |       | 5,703 |   | 9,529 |   |
| Minority  interest in income of Hiland Partners, LP                         |       | (867                                                                 | )          | (2,765                          | )          | (2,080 | ) | (8,991 | ) |
| **Net  income (loss)**                                                      |       | 1,735                                                                |       | (24                             | )          | 3,623 |   | 538 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| Less income  (loss) attributable to predecessor                             |       | —                                                               |       | (155                            | )          | — |   | 407 |   |
| **Limited  partners’ interest in net income**                          |       | $                                                                    | 1,735      |                            | $          | 131 |   | $ | 3,623 |   | $ | 131 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Net  income per limited partners’ unit - basic**                     |       | $                                                                    | 0.08       |                            | $          | 0.01 |   | $ | 0.17 |   | $ | 0.01 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Net  income per limited partners’ unit - diluted**                   |       | $                                                                    | 0.08       |                            | $          | 0.01 |   | $ | 0.17 |   | $ | 0.01 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Weighted  average limited partners’ units outstanding - basic**      |       | 21,600                                                               |       | 21,600                          |       | 21,600 |   | 21,600 |   |
|                                                                        |       |                                                                 |       |                            |       |   |   |   |   |
| **Weighted  average limited partners’ units outstanding - diluted**    |       | 21,609                                                               |       | 21,600                          |       | 21,610 |   | 21,600 |   |

 

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

 

4

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**HILANDHOLDINGS GP, LP**

 

**Consolidated Statements of Cash Flows**

 

**For theNine Months Ended (Unaudited)**

 
| ** **                                                                                                                                                                                                                              | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                              | ** ** | **2007**                | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                                                                                                              | ** ** | ** **              | ** ** | **Predecessor**        | ** ** |
| ** **                                                                                                                                                                                                                              | ** ** | **(in thousands)** | ** ** |
| **Cash  flows from operating activities:**                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Net income                                                                                                                                                                                                                              |       | $                       | 3,623      |                   | $          | 538 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                                                                                                                                      |       |                    |       |                   |       |
| Depreciation and  amortization                                                                                                                                                                                                          |       | 22,141                  |       | 16,209                 |       |
| Accretion of  asset retirement obligation                                                                                                                                                                                               |       | 81                      |       | 47                     |       |
| Amortization of  deferred loan cost                                                                                                                                                                                                     |       | 357                     |       | 402                    |       |
| Gain on  derivative transactions                                                                                                                                                                                                        |       | (510                    | )          | (133                   | )          |
| Unit based  compensation                                                                                                                                                                                                                |       | 1,033                   |       | 364                    |       |
| Minority  interest in income of Hiland Partners, LP                                                                                                                                                                                     |       | 2,080                   |       | 8,991                  |       |
| (Increase)  decrease in current assets:                                                                                                                                                                                                 |       |                    |       |                   |       |
| Accounts  receivable—trade                                                                                                                                                                                                         |       | 489                     |       | 4,057                  |       |
| Accounts  receivable—affiliates                                                                                                                                                                                                    |       | 379                     |       | 864                    |       |
| Other current  assets                                                                                                                                                                                                                   |       | 84                      |       | (94                    | )          |
| Increase  (decrease) in current liabilities:                                                                                                                                                                                            |       |                    |       |                   |       |
| Accounts  payable—trade                                                                                                                                                                                                            |       | (2,543                  | )          | 692                    |       |
| Accounts  payable—affiliates                                                                                                                                                                                                       |       | 675                     |       | (1,658                 | )          |
| Accrued  liabilities and other                                                                                                                                                                                                          |       | 286                     |       | 231                    |       |
| Increase in  other assets                                                                                                                                                                                                               |       | —                  |       | (144                   | )          |
| **Net  cash provided by operating activities**                                                                                                                                                                                          |       | 28,175                  |       | 30,366                 |       |
| ** **                                                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| **Cash  flows from investing activities:**                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Additions to  property and equipment                                                                                                                                                                                                    |       | (61,940                 | )          | (47,989                | )          |
| Payments for  businesses acquired, less cash received                                                                                                                                                                                   |       | —                  |       | (96,400                | )          |
| Proceeds from  disposals of property and equipment                                                                                                                                                                                      |       | —                  |       | 111                    |       |
| **Net  cash used in investing activities**                                                                                                                                                                                              |       | (61,940                 | )          | (144,278               | )          |
| ** **                                                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| **Cash  flows from financing activities:**                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Proceeds from  public offering-net of underwriters discount                                                                                                                                                                             |       | —                  |       | 139,617                |       |
| Proceeds from  long-term borrowings                                                                                                                                                                                                     |       | 54,100                  |       | 135,535                |       |
| Payments on  long-term borrowings                                                                                                                                                                                                       |       | —                  |       | (35,000                | )          |
| Payments on  capital lease obligations                                                                                                                                                                                                  |       | (178                    | )          | —                 |       |
| Debt issuance  costs                                                                                                                                                                                                                    |       | (494                    | )          | (1,280                 | )          |
| Offering costs                                                                                                                                                                                                                          |       | (157                    | )          | (1,772                 | )          |
| Cash  distribution to controlling members for net assets of Hiland Partners GP, LLC                                                                                                                                                     |       | —                  |       | (101,812               | )          |
| Capital  Contributions                                                                                                                                                                                                                  |       | —                  |       | 501                    |       |
| Proceeds from  Hiland Partners, LP unit options exercise                                                                                                                                                                           |       | 1,024                   |       | 1,094                  |       |
| Minority  interest cash distribution to unitholders of Hiland Partners, LP                                                                                                                                                              |       | (8,447                  | )          | (16,509                | )          |
| Cash  distribution to members of Hiland Partners GP, LLC                                                                                                                                                                                |       | —                  |       | (1,750                 | )          |
| Cash  distribution to unitholders                                                                                                                                                                                                       |       | (13,724                 | )          | —                 |       |
| **Net  cash provided by financing activities**                                                                                                                                                                                          |       | 32,124                  |       | 118,624                |       |
|                                                                                                                                                                                                                                    |       |                    |       |                   |       |
| Increase  (decrease) for the period                                                                                                                                                                                                     |       | (1,641                  | )          | 4,712                  |       |
| Beginning of  period                                                                                                                                                                                                                    |       | 10,569                  |       | 6,318                  |       |
| **End of  period**                                                                                                                                                                                                                      |       | $                       | 8,928      |                   | $          | 11,030 |   |
|                                                                                                                                                                                                                                    |       |                    |       |                   |       |
| Supplementary  information                                                                                                                                                                                                              |       |                    |       |                   |       |
| Cash paid for  interest, net of amounts capitalized                                                                                                                                                                                     |       | $                       | 7,489      |                   | $          | 4,649 |   |
| ** **                                                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| **Non-cash  investing and financing activities:**                                                                                                                                                                                       | ** ** | ** **              | ** ** | ** **             | ** ** |
|                                                                                                                                                                                                                                    |       |                    |       |                   |       |
| Property and  equipment financed under capital lease obligations                                                                                                                                                                        |       | $                       | 5,881      |                   |       |   |
|                                                                                                                                                                                                                                    |       |                    |       |                   |       |
| May 10, 2006  purchase of limited partner common units of Hiland Partners, LP in excess of  proportionate historical financial cost basis of Hiland Partners, LP  allocated to property and equipment and intangible assets as follows: |       |                    |       |                   |       |
|                                                                                                                                                                                                                                    |       |                    |       |                   |       |
| Property and  equipment                                                                                                                                                                                                                 |       |                    |       | 4,488                  |       |
| Customer  contracts                                                                                                                                                                                                                     |       |                    |       | 6,980                  |       |
| Excess of cost  over proportionate equity interest                                                                                                                                                                                      |       |                    |       | $                      | 11,468     |   |

 

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

 

5

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**HilandHoldings GP, LP**

 

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

 

**For theNine Months Ended September 30, 2007 (Unaudited)**

 
| ** **                                                                           | ** ** | ** **              | ** ** | **Accumulated**   | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|------------|------------|-------------------|------------|
| ** **                                                                           | ** ** | ** **              | ** ** | **Other**         | ** ** | ** ** | ** ** | **Total**         | ** ** |
| ** **                                                                           | ** ** | **Common**              | ** ** | **Comprehensive** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                           | ** ** | **Units**               | ** ** | **Income**        | ** ** | **Total**  | ** ** | **Income**        | ** ** |
| ** **                                                                           | ** ** | **(in thousands)** | ** ** |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| **Balance,  January 1, 2007**                                                   |       | $                       | 38,590     |              | $          | 2,567      |       | $                 | 41,157     |   |   |   |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| Periodic cash  distributions                                                         |       | (13,724                 | )          | —            |       | (13,724    | )          |              |       |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| Unit based  compensation                                                             |       | 444                     |       | —            |       | 444        |       |              |       |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| Other  comprehensive income reclassified to income on closed derivative transactions |       | —                  |       | (1,346            | )          | (1,346     | )          | $                 | (1,346     | ) |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| Change in fair  value of derivatives                                                 |       | —                  |       | (808              | )          | (808       | )          | (808              | )          |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| Net income                                                                           |       | 3,623                   |       | —            |       | 3,623      |       | 3,623             |       |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| Comprehensive  income                                                                |       |                    |       |              |       |       |       | $                 | 1,469      |   |
|                                                                                 |       |                    |       |              |       |       |       |              |       |
| **Balance  September 30, 2007**                                                      |       | $                       | 28,933     |              | $          | 413        |       | $                 | 29,346     |   |   |   |

 

The accompanying notesare an integral part of this consolidated financial statement.

 

6

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**HILANDHOLDINGS GP, LP**

 

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

 

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006**

 

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

 

**Note 1:Organization, Basis of Presentation and Principles 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 ContinentalGas, Inc. and Hiland Partners, LLC. Hiland Partners commencedoperations on February 15, 2005, and concurrently with the completion ofits initial public offering, Continental Gas, Inc. contributed asubstantial portion of its net assets to Hiland Partners. The transfer ofownership of net assets from Continental Gas, Inc. to Hiland Partnersrepresented a reorganization of entities under common control and was recordedat historical cost. Continental Gas, Inc. was formed in 1990 as a whollyowned subsidiary of Continental Resources, Inc.

 

ContinentalGas, Inc. operated in one segment, midstream, which involved thegathering, compressing, dehydrating, treating, and processing of natural gasand fractionating 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 and Bakkengathering systems. Hiland Partners, LLC historically owned the Worlandgathering system and compression services assets, which Hiland Partnersacquired on February 15, 2005, and the Bakken gathering system. Since itsinitial public offering, Hiland Partners has operated in midstream andcompression services segments. On September 26, 2005, Hiland Partnersacquired Hiland Partners, LLC, which at such time owned the Bakken gatheringsystem, for $92.7 million, $35.0 million of which was used to retireoutstanding Hiland Partners, LLC indebtedness. On May 1, 2006, HilandPartners acquired the Kinta Area gathering assets from Enogex GasGathering, L.L.C., consisting of certain eastern Oklahoma gas gatheringassets, for $96.4 million.  Hiland Partners financed this acquisition with$61.2 million of borrowings from its credit facility and $35.0 million ofproceeds from the issuance to Hiland Partners GP, LLC, its general partner, of761,714 common units and 15,545 general partner equivalent units, both at$45.03 per unit.

 

The unaudited financialstatements for the three and nine months ended September 30, 2007 and 2006included herein have been prepared in accordance with the instructions forinterim reporting as prescribed by the United States Securities and ExchangeCommission (the “SEC”). The interim financial statements reflect alladjustments, which are in the opinion of our management, necessary for a fairpresentation of our results for the interim periods. Such adjustments areconsidered to be of a normal recurring nature. Results of operations for thethree and nine months ended September 30, 2007 are not necessarily indicativeof the results of operations that will be realized for the year ending December31, 2007.  The accompanying consolidated financial statements and notesthereto should be read in conjunction with the consolidated financialstatements and notes thereto included in our Form 10-K for the fiscal yearended December 31, 2006.

 

***Principles of Consolidation***

 

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. The consolidated financialstatements include the assets of Hiland Partners GP, LLC that were contributedto us concurrently with the completion of our initial public offering onSeptember 25, 2006. Hiland Partners GP, LLC commenced operations onFebruary 15, 2005, therefore amounts presented in these consolidatedfinancial statements and accompanying notes for the period January 1, 2006to September 25, 2006 relate to the consolidated accounts of HilandPartners GP, LLC, Hiland Partners and its subsidiaries.

 

7

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***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. Fair value of our derivative instruments isdetermined based on management estimates through utilization of market dataincluding forecasted forward natural gas and natural gas liquid (NGL) prices asa function 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 a hedge, the price movementsin the commodity derivatives must be highly correlated with the underlying hedgedcommodity. Gains and losses related to commodity derivatives which qualify ashedges are recognized in income when the underlying hedged physical transactioncloses and are included in the consolidated statements of operations asrevenues from midstream operations. Gains and losses related to commodityderivatives that are not designated as hedges or do not qualify as hedges arerecognized in income immediately, and are included in midstream revenues in theconsolidated statement of operations.

 

SFAS No. 133, asamended, establishes accounting and reporting standards for derivativeinstruments, including certain derivative instruments embedded in othercontracts, and for hedging activities. SFAS No. 133 requires that anentity recognize all derivatives as either assets or liabilities in thestatement of financial position and measure those instruments at fair value.However, if a derivative does qualify for hedge accounting, depending on thenature of the hedge, changes in fair value can be offset against the change infair value of the hedged item through earnings or recognized in othercomprehensive income until such time as the hedged item is recognized inearnings. To qualify for cash flow hedge accounting, the cash flows from thehedging instrument must be highly effective in offsetting changes in cash flowsdue to changes in the underlying item being hedged. In addition, all hedgingrelationships must be designated, documented, and reassessed periodically. SFASNo. 133 also provides that normal purchases and normal sales contracts arenot subject to the statement. Normal purchases and normal sales are contractsthat provide for the purchase or sale of something other than a financialinstrument or derivative instrument that will be delivered in quantitiesexpected to be used or sold by the reporting entity over a reasonable period inthe normal course of business. Our fixed price physical forward natural gaspurchase and sales contracts in which we have contracted to purchase or sellnatural gas quantities at fixed prices are designated as normal purchases andsales. Substantially all forward contracts fall within a one to 24 month term.

 

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 in owners’ equity andreclassified into earnings in the same period in which the hedged transactioncloses. The asset or liability related to the derivative instruments isrecorded on the balance sheet as fair value of derivative assets or liabilities.Any ineffective portion of the gain or loss is recognized in earningsimmediately.

 

***Comprehensive Income***

 

Comprehensive incomeincludes net income and other comprehensive income, which includes, but is notlimited to, changes in the fair value of derivative financial instruments.Pursuant to SFAS No. 133, for derivatives qualifying as hedges, theeffective portion of changes in fair value are recognized in owners’ equity asaccumulated other comprehensive income and reclassified to earnings when the underlyinghedged physical transaction closes, to the extent of our interest in HilandPartners. Our comprehensive income for the three and nine months endedSeptember 30, 2007 and 2006 is presented in the table below:

 

8

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| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                             | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net income                                             |       | $                                | 1,735      |                            | $          | (24 | ) | $ | 3,623 |   | $ | 538 |   |
| Closed  derivative transactions reclassified to income |       | (511                             | )          | (1,275                          | )          | (1,346 | ) | (1,424 | ) |
| Change in fair  value of derivatives                   |       | (15                              | )          | 3,933                           |       | (808 | ) | 4,116 |   |
| Comprehensive  Income                                  |       | $                                | 1,209      |                            | $          | 2,634 |   | $ | 1,469 |   | $ | 3,230 |   |

 

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

 

Net income per limitedpartners’ unit is computed based on the weighted-average number of common unitsoutstanding during the period. The computation of diluted net income perlimited partner unit further assumes the dilutive effect of restricted unitsawarded. Net income per limited partners’ unit is computed by dividing netincome applicable to limited partners by both the basic and dilutedweighted-average number of limited partnership units outstanding.

 

***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 nine months ended September 30, 2007 or 2006. OnMay 1, 2006, Hiland Partners acquired the Kinta Area gathering assets andrecorded identifiable customer relationships of $10,492. On May 10, 2006,Hiland Partners GP, LLC purchased 761,714 common units and 15,545 generalpartner units of Hiland Partners for $35.0 million. Hiland Partners GP,LLC recorded an additional $6,979 in contracts to sell natural gas for aportion of the amount that the purchase price exceeded the proportionateinterest in the underlying equity of Hiland Partners.

 

Intangible assetsconsisted of the following for the periods indicated:

 

| ** **                     | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                     | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| 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 |       | 13,094                 |       | 8,477                 |       |
| Intangible  assets, net        |       | $                      | 48,477     |                  | $          | 53,094 |   |

 

During the three monthsended September 30, 2007 and 2006, we recorded amortization expense of $1,539and $1,451, respectively, and during the nine months ended September 30, 2007and 2006, we recorded amortization expense of $4,617 and $3,928, respectively.Estimated aggregate amortization expense for the remainder of 2007 is $1,540and $6,157 for each of the four succeeding fiscal years from 2008 through 2011and a total of $22,309 for all years thereafter.

 

***Accounting for Asset Retirement Obligations***

 

In accordance with SFASNo. 143, “Accounting for Asset Retirement Obligations,” 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 this standard primarily apply to dismantlement and siterestoration of certain of our plants and pipelines. During the nine monthsended September 30, 2007, we incurred asset retirement obligations on new andexisting plant and compressor locations under lease. We have also evaluatedexisting asset retirement obligations and have made revisions in the carryingvalues as of September 30, 2007.

 

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

 

| Asset retirement  obligation, January 1, 2007 |   | $    | 2,196  |   |
|----------------------------------------------------|--------|------|--------|--------|
| Add: additions  on leased locations                |   | 588  |   |
| Revisions of  prior estimates                      |   | (292 | )      |
| Add: accretion  expense                            |   | 81   |   |
| Asset retirement  obligation, September 30, 2007   |   | $    | 2,573  |   |

 

***Minority Interests***

 

The minority interest onour consolidated balance sheets as of September 30, 2007 and December 31, 2006reflects the outside ownership interest of Hiland Partners. Minority interestin income is calculated by multiplying the minority interest owners’proportionate ownership of limited partner units in Hiland Partners by thelimited partners’ allocation of Hiland Partners’ net income. Hiland Partners’net income is allocated to its limited partners and its general partner basedon the proportionate share of the contractually-determined cash distributionsfor the period, with adjustments made for incentive distributions specificallyallocated to its general partner. All amounts we have received from HilandPartners’ issuance and sale of limited partner units have been recorded asincreases to the minority interest balance on the consolidated balance 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 may elect to makecontributions to Hiland Partners each time Hiland Partners issues common unitsin order to maintain its 2% general partner ownership in Hiland Partners.Hiland Partners GP, LLC contributed to Hiland Partners $6 and $10 for the threemonths ended September 30, 2007 and 2006, respectively and $27 and $30 for thenine months ended September 30, 2007 and 2006, respectively to maintain its 2%general partner ownership.

 

***Share-Based Compensation***

 

Hiland Holdings GP, LP Long Term Incentive Plan

 

Hiland Holdings GP, thegeneral partner of Hiland Holdings, adopted the Hiland Holdings GP, LPLong-Term Incentive Plan for its employees and directors of its general partnerand employees of its affiliates. The long-term incentive plan consists of threecomponents: unit options, restricted units and phantom units. The long-termincentive plan limits the number of units that be delivered pursuant to awardsto 2,160,000 units. The plan is administered by our general partner’s board ofdirectors or its compensation committee. The plan will expire upon the first tooccur 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.

 

Our general partner’sboard of directors or the compensation committee may terminate or amend thelong-term incentive plan at any time with respect to any units for which agrant has not yet been made. Our board of directors and the compensationcommittee of the board also have the right to alter or amend the long-termincentive plan or any part of the plan from time to time, including increasingthe number of units that may be granted subject to unitholder approval as maybe required by applicable law or stock exchange rules. However, no change inany outstanding grant may be made that would materially reduce the benefits ofthe participant without the consent of the participant. Under the unit optiongrant agreement, granted options of common units will vest and becomeexercisable in one-third increments on the anniversary of the grant date overthree years. Vested options are exercisable within the option’s contractuallife of ten years after the grant date.  Our restricted and phantom unitsvest in one-quarter increments on the anniversary of the grant date over fouryears.

 

In October 1995, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123, “Share-BasedPayment,” which was revised in December 2004 (“SFAS 123R”). SFAS 123Rrequires that the compensation cost relating to share-based paymenttransactions be recognized in the financial statements and that cost bemeasured based on the fair value of the equity or liability instruments issued.We adopted SFAS 123R effective January 1, 2006 and have used thepermitted modified prospective method beginning as of the same date.

 

No options were issued orare outstanding for the three or nine months ended September 30, 2007.

 

No phantom units wereissued or are outstanding for the three or nine months ended September 30,2007.

 

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The following tablesummarizes our information about vesting restricted units for the nine monthsended September 30, 2007:

 

| **Restricted Units**           | ** ** | **Units** | ** ** | **Weighted Average  Fair Value at  Grant Date ($ )** | ** ** |
|-------------------------------------|------------|-----------|------------|------------------------------------------------------------------------------------|------------|
| Non-vested at  January 1, 2007 |       | 12,000    |       | $                                                                                  | 20.00      |   |
| Granted                             |       | 6,000     |       | $                                                                                  | 28.25      |   |
| Vested                              |       | (3,000    | )          | $                                                                                  | 20.00      |   |
| Forfeited                           |       | —    |       | $                                                                                  | —     |   |
| Non-vested at  September 30, 2007   |       | 15,000    |       | $                                                                                  | 23.30      |   |

 

A restricted unit is acommon unit that is subject to forfeiture. Upon vesting, the grantee receives acommon unit that is not subject to forfeiture. The restricted units vest over afour-year period from the date of issuance. Periodic distributions on therestricted units are held in trust by our general partner until the units vest.As provided for in our long-term incentive plan, each non-employee board memberof Hiland Partners GP Holdings, LLC on each anniversary date of their initialreward is entitled to receive an additional 1,000 restricted common units. Wegranted 1,000 restricted units to each of our six independent directors duringthe three months ended September 30, 2007. As of September 30, 2007, 3,000 ofthe restricted units issued in 2006 vested and were converted to common units.Compensation expense related to the restricted units issued is to be recognizedover their respective four-year vesting period on the graded vestingattribution method. We recorded compensation expense related to the restrictedunits issued of $33 and $1 for the three months ended September 30, 2007 and2006, respectively and $96 and $1 for the nine months ended September 30, 2007and 2006, respectively and we will record additional compensation expense of$298 over the next four years.

 

On February 15,2005, Hiland Partners GP, LLC issued member based compensation awards with afair value of $118 to two of its members, Randy Moeder, our former ChiefExecutive Officer, President and director of our general partner and KenMaples, our Chief Financial Officer, Vice President-Finance, Secretary anddirector of our general partner as compensation for services to be renderedexclusively for Hiland Partners GP, LLC’s benefit. In connection with theclosing of our initial public offering, these Class B member interestswere exchanged for a calculated number of our Class B common units, which hadequal fair value. The Class B common units vest over a three-year periodfrom the date of issuance. The Class B common units have substantially thesame rights as the common units and, upon vesting, become convertible at theelection of the holder into common units. Member based compensation expenserelated to the Class B common units was $1 and $8 for three months endedSeptember 30, 2007 and 2006, respectively and $348 and $25 for the nine monthsended September 30, 2007 and 2006, respectively.

 

On March 14, 2007, Mr.Moeder announced his intention to resign. In connection with Mr. Moeder’sresignation, we and our general partner entered into a retention agreement withMr. Moeder that allowed Mr. Moeder to continue his employment for a mutuallyagreeable period of time, but no longer than nine months. Under the agreement,as long as Mr. Moeder continued his employment, a pro rata portion of his72,249 unvested Class B common units in us would vest. The Class B common unitsthat did not vest would be forfeited to Hiland Holdings and distributed prorata to Harold Hamm, The Harold Hamm DST Trust, The Harold Hamm HJ Trust andKen Maples. Accordingly, as required by SFAS 123R “Share-Based Payment,” asamended, on March 14, 2007 we recalculated the fair value of the remainingunvested Class B common units as a modification of the units awarded to Mr.Moeder on February 15, 2005. We used the American Binomial option pricing modeland recalculated the fair value of the unvested Class B common units at $30.32per unit.

 

On April 16, 2007, Mr.Moeder resigned and 11,877 of his 72,249 unvested Class B common units vestedand converted to common units. As a result of the recalculated fair value of$30.32 per unit, we recorded an additional $343 of expense for the period fromMarch 15, 2007 through April 16, 2007. On the same day, Mr. Moeder forfeitedthe remaining 60,372 unvested Class B common units.

 

***Hiland Partners, LPLong Term Incentive Plan***

 

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) the date determined by the board of directors of the general partner;(ii) the date that common units are no longer available for payment ofawards under the plan; 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,

 

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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 will vest and become exercisable in one-thirdincrements on the anniversary of the grant date over three years. Vestedoptions are exercisable within the option’s contractual life of ten years afterthe grant date. Restricted and phantom units vest in one-quarter increments onthe anniversary of the grant date over four years.

 

On June 19, 2007, HilandPartners granted 10,000 phantom units under its long-term incentive Plan to thenew Chief Executive Officer, Joseph L. Griffin. A phantom unit is a common unitthat is subject to forfeiture and is not considered issued until it vests. Uponvesting, Mr. Griffin will receive a common unit that is not subject toforfeiture, cash in lieu of the delivery of such unit equal to the fair marketvalue of the unit on the vesting date, or a combination thereof, at thediscretion of Hiland Partners’ general partner’s board of directors. Similar torestricted units, the phantom units vest over a four-year period from the dateof issuance and distributions on the phantom units will be held in trust byHiland Partners general partner until the units vest. During the three and ninemonths ended September 30, 2007, Hiland Partners incurred compensation expenseof $73 and $81 related to the phantom units and will recognize additionalexpense of $464 over the next four years.  Hiland Partners had not grantedany phantom units prior to June 19, 2007.

 

Hiland Partners did notgrant any unit options during the nine months ended September 30, 2007. Thefair values of each option granted during the nine months ended September 30,2006 were estimated on the date of grant using the American Binomial optionpricing model that used expected volatility ranges from 16.1% to 20.2%, aweighted-average volatility of 18.0%, an expected dividend yield of 5.2% and arisk-free interest rate of 4.5%. Expected and weighted-average volatility wasbased on peer group volatility averages as determined on the option grantdates. Expected lives of 6.0 years are calculated by the simplified method asprescribed under SEC Staff Accounting Bulletin 107 and represented the periodof time that unit options granted are expected to be outstanding. The risk-freeinterest rate for periods within the contractual life of the option is based onthe U.S. Treasury yield in effect at the time of grant. The exercise price ofthe options granted equaled the market price of the units on the grant date.

 

The following tablesummarizes information about outstanding options with respect to HilandPartners’ common units for the nine months ended September 30, 2007:

 

| ** **                           | ** ** | ** ** | ** ** | ** **               | ** ** | **Weighted-**   | ** ** | ** **    | ** ** |
|--------------------------------------|------------|------------|------------|--------------------------|------------|-----------------|------------|---------------|------------|
| ** **                           | ** ** | ** ** | ** ** | **Weighted**             | ** ** | **Average**     | ** ** | **Aggregate** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | **Average**              | ** ** | **Remaining**   | ** ** | **Intrinsic** | ** ** |
| ** **                           | ** ** | ** ** | ** ** | **Exercise**             | ** ** | **Contractual** | ** ** | **Value**     | ** ** |
| **Options**                          | ** ** | **Units**  | ** ** | **Price ($ )** | ** ** | **Term**        | ** ** | **($ )** | ** ** |
| Outstanding at  January 1, 2007 |       | 128,468    |       | $                        | 28.24      |            |       |          |       |   |
| Granted                              |       | —     |       | $                        | —     |            |       |          |       |   |
| Exercised                            |       | (42,362    | )          | $                        | 24.16      |            |       |          | $          | 1,394 |   |
| Forfeited or  expired                |       | (10,767    | )          | $                        | 22.50      |            |       |          |       |   |
| Outstanding at  September 30, 2007   |       | 75,339     |       | $                        | 31.08      |            | 7.9        |          | $          | 1,382 |   |
| Exercisable at  September 30, 2007   |       | 20,005     |       | $                        | 33,31      |            | 8.0        |          | $          | 322 |   |

 

In connection with Mr.Moeder’s resignation (see also Hiland Holdings GP, LP Long Term Incentive Planabove), his unit option agreement was modified on March 14, 2007, so that  Mr. Moeder’s 10,666 unvested Hiland Partners’options to purchase Hiland Partners common units would vest pro rata as long asMr. Moeder continued his employment. Accordingly, as required by SFAS 123R “Share-BasedPayment,” as amended, on March 14, 2007, Hiland Partners recalculated the fairvalue of the remaining unvested options to purchase Hiland partners commonunits as a modification of the options awarded to Mr. Moeder on February 10,2005. The recalculated fair value of the options of $33.65 per unit, wasdetermined by using the American Binomial option pricing model.

 

On April 16, 2007, Mr.Moeder resigned and 1,899 of his 10,666 unvested Hiland Partners’ options topurchase Hiland Partners’ common units vested. As a result of the recalculatedfair value of $33.65 per unit, Hiland Partners recorded an additional $24 ofexpense for the period from March 15, 2007 through April 16, 2007. On the sameday, Mr. Moeder forfeited his remaining 8,767 unvested Hiland Partners unitoptions. The forfeiture of Mr. Moeder’s 8,767 unvested unit options reducedcompensation expense for the period from April 1, 2007 through April 16, 2007by $16. On April 19, 2007, Mr. Moeder exercised his 1,899 vested options topurchase Hiland Partners common units.

 

As a result of adoptingSFAS 123R on the modified prospective basis beginning on January 1,2006, during the three months ended September 30, 2007 and 2006, Hiland Partnersexpensed $34 and $89, respectively and during the nine months ended September30, 2007 and 2006, Hiland Partners expensed $131 and $268, respectively allrelated to unit options that were awarded in both 2006 and 2005.

 

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The following tablesummarizes information about Hiland Partners restricted common units for thenine months ended September 30, 2007:

 

| ** **                        | ** ** | ** ** | ** ** | **Weighted**            | ** ** |
|-----------------------------------|------------|------------|------------|-------------------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Average**             | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Fair Value**     | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **At Grant**       | ** ** |
| **Restricted Units**         | ** ** | **Units**  | ** ** | **Date ($ )** | ** ** |
|                              |       |       |       |                    |       |
| Non-vested at  January 1, 2007    |       | 19,000     |       | $                       | 44.12      |   |
|                              |       |       |       |                    |       |
| Granted                           |       | 6,000      |       | $                       | 51.95      |   |
|                              |       |       |       |                    |       |
| Vested                            |       | (4,000     | )          | $                       | 42.05      |   |
|                              |       |       |       |                    |       |
| Forfeited or  expired             |       | —     |       | $                       | —     |   |
|                              |       |       |       |                    |       |
| Non-vested at  September 30, 2007 |       | 21,000     |       | $                       | 46.75      |   |

 

As provided for in HilandPartners long-term incentive plan, each non-employee board member of itsgeneral partner on each anniversary date of the initial award is entitled toreceive an additional 1,000 Hiland Partners restricted common units. Accordingly,Hiland Partners issued a total of 6,000 restricted units to its sixnon-employee board members of its general partner during the three months endedSeptember 30, 2007. Also during the three months ended September 30, 2007, atotal of 4,000 restricted units issued to non-employee board members of itsgeneral partner in 2005 and 2006 vested and were converted into Hiland Partnerscommon units. Hiland Partners issued no other restricted units during the threeand nine months ended September 30, 2007. A restricted unit is a common unitthat is subject to forfeiture. The restricted units vest over a four-yearperiod from the date of issuance. Periodic distributions on the restrictedunits are held in trust by its general partner until the units vest. Uponvesting, the grantee receives a common unit that is not subject to forfeiture.

 

Total compensationexpense related to phantom and restricted units was $210 and $31 for the threemonths ended September 30, 2007 and 2006, respectively and $458 and $70 for thenine months ended September 30, 2007 and 2006, respectively. As of September30, 2007, there was $1,168 of total unrecognized compensation cost related toHiland Partners’ unvested phantom and restricted units granted. This cost is tobe recognized over a weighted average period of two years.

 

***Recent Accounting Pronouncements***

 

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities”. SFAS No. 159 expands opportunities to use fairvalue measurement in financial reporting and permits entities to choose tomeasure many financial instruments and certain other items at fair value. SFASNo. 159 is effective for fiscal years beginning after November 15,2007. We believe we will not choose to measure any eligible financial assetsand liabilities at fair value.

 

In September 2006,the FASB issued SFAS No. 157 “Fair Value Measurements.”  SFASNo. 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 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. SFASNo. 157 applies to derivatives and other financial instruments, whichStatement 133,*  Accounting for Derivative Instruments andHedging Activities* , as amended, requires be measured at fair valueat initial recognition and for all subsequent periods. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007 and interim periods within those fiscal years. We willapply the provisions of SFAS No. 157 prospectively in our first interimperiod in the fiscal year beginning on January 1, 2008, and we do notexpect a change in our methodologies of fair value measurements.

 

**Note2: Initial Public Offering**

 

On May 26, 2006, aRegistration Statement on Form S-1 was filed with the SEC relating to aproposed initial public offering of limited partnership interests in HilandHoldings. On September 13, 2006, the SEC declared our registrationstatement on Form S-1 effective. On September 19, 2006, we priced7,000,000 common units in connection with our initial public offering at aprice of $18.50 per unit. On September 20, 2006, our common units begantrading on the NASDAQ National Market under the symbol “HPGP.” OnSeptember 25, 2006, we closed our initial public offering of 8,050,000common units, which included 1,050,000 common units issued pursuant to anover-allotment option that was exercised by the underwriters. Total proceedsfrom the sale of the units were $139.6 million, net of $9.3 million ofunderwriting commissions.

 

In connection with theclosing of our initial public offering, all of the membership interests inHiland Partners GP, LLC (which

 

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owns the 2% general partner interest and all of the incentivedistribution rights in Hiland Partners), 1,301,471 Hiland Partners common units(including 761,714 Hiland Partners common units previously owned by HilandPartners GP, LLC) and 4,080,000 subordinated units of Hiland Partners werecontributed to us, resulting in our ownership of a 57.0% limited partnerinterest in Hiland Partners. Contributions of Hiland Partners GP, LLC’s assetsare reflected at their historical carrying basis because the contributions arefrom a related party. As consideration for this contribution, substantially allof the net proceeds from our initial public offering, after the retirement of$36.0 million of outstanding debt and accrued interest of Hiland Partners GP,LLC, were distributed to Harold Hamm, The Harold Hamm DST Trust, The HaroldHamm HJ Trust, Randy Moeder and Ken Maples (the “Contributing Parties”) and13,550,000 common units and Class B common units in us were issued to theContributing Parties.

 

**Note 3:Acquisition**

 

*KintaArea Gathering System*.   On May 1, 2006,Hiland Partners acquired certain gas gathering assets from Enogex GasGathering, L.L.C. for $96.4 million cash, including certain closing costs,financed with borrowings under its credit facility and an additional notepayable to a bank. We refer to these assets as the Kinta Area gathering assets.A determination was made by our management of the fair value of these assetsand liabilities primarily using current replacement cost for the acquired gasgathering assets and related equipment less estimated accumulated depreciationon such replacement costs and estimated discounted cash flows arising fromfuture renegotiated customer contracts. The acquired assets, which are locatedin the eastern Oklahoma Arkoma Basin, have approximately 672 wellhead receiptpoints and include five separate low pressure natural gas gathering systemsconsisting of 569 miles of natural gas gathering pipelines and 23 compressorunits capable of nearly 40,000 horsepower of compression. The natural gasgathering systems operate under contracts with producers that provide forservices under fixed-fee arrangements. Hiland Partners operates the Kinta Areagathering assets substantially differently than they were operated by theprevious owner. Since there was no sufficient continuity of the Kinta Areagathering assets’ operations prior to and after the acquisition, disclosure ofprior financial information would not be material to an understanding of futureoperations. Therefore, the acquisition has been recorded as a purchase ofassets and not a business, and no pro forma financial information is requiredto be presented.

 

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

 

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

 

The Kinta Area gatheringassets and operations are included in the consolidated financial statementsfrom May 1, 2006 forward.

 

**Note 4: Property andEquipment**

 

| ** **                                       | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Land                                             |       | $                      | 295        |                  | $          | 255 |   |
| Construction in  progress                        |       | 26,660                 |       | 48,610                |       |
| Midstream  pipeline, plants and compressors      |       | 324,874                |       | 230,645               |       |
| Compression and  water injection equipment       |       | 19,267                 |       | 19,270                |       |
| Other                                            |       | 3,769                  |       | 2,471                 |       |
|                                             |       | 374,865                |       | 301,251               |       |
| Less:  accumulated depreciation and amortization |       | 61,772                 |       | 44,248                |       |
|                                             |       | $                      | 313,093    |                  | $          | 257,003 |   |

 

On May 10, 2006,Hiland Partners GP, LLC purchased 761,714 common units and 15,545 generalpartner units of Hiland Partners for $35.0 million. Hiland Partners GP,LLC recorded additional pipeline and processing plant cost of $4,488 for aportion of the amount that the unit purchase price exceeded the proportionateinterest in the underlying equity of Hiland Partners.

 

During the three and ninemonths ended September 30, 2007, we capitalized interest of $828 and $2,281,respectively. During the three and nine months ended September 30, 2006, wecapitalized interest of $479 and $811, respectively.

 

**Note 5: Derivatives**

 

Hiland Partners hasentered into certain financial swap instruments that are classified as cashflow hedges in accordance with SFAS No. 133, as amended, and relate toforecasted sales in 2007, 2008 and 2009. Hiland Partners entered into theseinstruments to hedge forecasted natural gas and natural gas liquids (NGLs)sales or purchases against the variability in expected future cash flows 

 

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attributable to changes in commodity prices. Under several of thesecontractual swap agreements with Hiland Partners’ counterparties, HilandPartners receives a fixed price and pays a floating price based on certainindices for the relevant contract period as the underlying natural gas or NGLis sold. In other agreements, Hiland Partners pays a fixed price and receives afloating price based on certain indices for the relevant contract period as theunderlying natural gas is purchased. Hiland Partners has also entered into onefinancial swap instrument that currently does not qualify for hedge accountingas discussed below.

 

Hiland Partners formallydocuments all relationships between hedging instruments and the items beinghedged, including its risk management objective and strategy for undertakingthe hedging transactions. This includes matching the natural gas and NGLfutures, the “sold fixed for floating price” or “buy fixed for floating price”contracts, to the forecasted transactions. 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 owners’ equity as accumulated other comprehensiveincome 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 recognized as an adjustmentto midstream revenue while the hedge contract is open and may increase ordecrease until settlement of the contract. Realized cash gains and losses on closed/settledinstruments are reflected in the contract month being hedged as an adjustmentto midstream revenues.

 

On July 16, 2007, HilandPartners entered into financial swap instruments with BP Energy Company relatedto forecasted sales for the periods from August 1, 2007 through calendar year2008 whereby Hiland Partners receives a fixed price and pays a floating pricebased on certain indices for the relevant contract period as the underlyingnatural gas and NGLs are sold. These financial swap instruments are classifiedas cash flow hedges in accordance with SFAS No. 133, as amended.

 

On May 9, 2007, HilandPartners entered into a financial swap instrument with BP Energy Companyrelated to forecasted sales in 2008 whereby we receive a fixed price and pay afloating price based on certain indices for the relevant contract period as theunderlying natural gas is sold. This financial swap instrument is classified asa cash flow hedge in accordance with SFAS No. 133, as amended.

 

On March 15, 2007, HilandPartners entered into two separate financial swap instruments with BP EnergyCompany that relate to forecasted sales in 2009. In one instrument HilandPartners receives a fixed price and pays a floating price based on certainindices for the relevant contract period as the underlying natural gas is sold.This financial swap instrument is classified as a cash flow hedge in accordancewith SFAS No. 133, as amended. In the other instrument, currentlydesignated as an open trade, Hiland Partners receives a NYMEX index price lessa basis differential and pays a floating price based on certain indices for therelevant contract period as the underlying natural gas is sold. The open tradefinancial swap instrument has not been designated as a hedge. The forecasted non-cashunrealized gain on the open trade financial swap instrument has been recordedas an increase in midstream revenues in the current period.

 

During the three and ninemonths ended September 30, 2007, we reclassified net gains of $511 and $1,346on closed/settled hedge transactions to midstream revenues out of accumulatedother comprehensive income. We also recorded $15 and $808 out of accumulatedother comprehensive income for the decrease in fair value of open derivativesfor the three and nine months ended September 30, 2007, respectively. Includedin minority interest on the balance sheet is $1,511 of the changes in the netfair value of derivatives during the nine months ended September 30, 2007attributable to minority interest. As of September 30, 2007, our accumulatedother comprehensive income related to derivatives was $413. Of this amount weanticipate $256 will be reclassified to earnings during the next 12 months and$157 will be reclassified to earnings in subsequent periods. During the threeand nine months ended September 30, 2007, Hiland Partners recorded gains of$305 and $486, respectively on the non-qualifying open trade financialinstrument and net gains of $33 and $136, respectively on the ineffectiveportions of qualifying open derivative transactions.

 

During the three and ninemonths ended September 30, 2006, we reclassified net gains of $1,275 and $1,424on closed/settled hedge transactions to midstream revenues out of accumulatedother comprehensive income and also recorded $3,933 and $4,116, respectivelyinto accumulated other comprehensive income for the favorable change in fairvalue of open derivatives. During the nine months ended September 30, 2006, werecorded $2,922 to minority interest on the consolidated balance sheet relatedto changes in the net fair value of open derivatives. During the three and ninemonths ended September 30, 2006, As of September 30, 2006, our accumulatedother comprehensive income related to derivatives was $2,713. Hiland Partnersrecorded losses of $31 and gains of $133, respectively, on the ineffectiveportions of qualifying open derivative transactions.

 

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The fair value ofderivative assets and liabilities are as follows for the indicated periods:

 

| ** **                                           | ** ** | **As of  September 30,  2007** | ** ** | **As of  December 31,  2006** | ** ** |
|------------------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| Fair value of  derivative assets—current        |       | $                                        | 4,144      |                                    | $          | 4,707 |   |
| Fair value of  derivative assets—long term      |       | 1,177                                    |       | 1,955                                   |       |
| Fair value of  derivative liabilities—current   |       | (3,660                                   | )          | (1,902                                  | )          |
| Fair value of  derivative liabilities—long term |       | (347                                     | )          | (291                                    | )          |
| Net fair value  of derivatives                       |       | $                                        | 1,314      |                                    | $          | 4,469 |   |

 

The terms of ourderivative contracts currently extend out as far as December 2009. Thecounterparties to all derivative contracts are BP Energy Company. Set forthbelow is the summarized notional amount and terms of all instruments held forprice risk management purposes at September 30, 2007.

 

| ** **                                                        | ** ** | ** **  | ** ** | ** **           | ** ** | **Fair Value** | ** ** |
|-------------------------------------------------------------------|------------|-------------|------------|----------------------|------------|---------------------|------------|
| ** **                                                        | ** ** | ** **  | ** ** | **Average**          | ** ** | **Asset**           | ** ** |
| **Description and Production Period**              | ** ** | **Volume**  | ** ** | **Fixed Price** | ** ** | **(Liability)**     | ** ** |
|                                                              |       |        |       |                 |       |                |       |
| **Natural  Gas—Sold Fixed for Floating Price Swaps**         | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**      | ** ** | ** **          | ** ** |
| October 2007  - September 2008                          |       | 1,890,000   |       | $                    | 7.88       |                | $          | 4,144 |   |
| October  2008-December 2008                                       |       | 495,000     |       | 7.84                 |       | 485                 |       |
| January 2009  - December 2009                           |       | 1,068,000   |       | $                    | 7.06       |                | 186        |   |
|                                                              |       |        |       |                 |       | $                   | 4,815      |   |
| ** **                                                        | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| **Natural  Gas - Sold Open for Floating Price Swaps**             | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**      | ** ** | ** **          | ** ** |
| January 2009 -  December 2009                                     |       | 1,068,000   |       | $                    | 7.35       |                | $          | 485 |   |
|                                                              |       |        |       |                 |       |                |       |
| **Natural  Gas—Buy Fixed for Floating Price Swaps**          | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**      | ** ** | ** **          | ** ** |
| October 2007 –  September 2008                          |       | 859,986     |       | $                    | 7.48       |                | $          | (963 | ) |
| October 2008 –  December 2008                                |       | 180,288     |       | 6.93                 |       | 21                  |       |
|                                                              |       |        |       |                 |       | (942)               |       |
|                                                              |       |        |       |                 |       |                |       |
| **Natural  Gas Liquids—Sold Fixed for Floating Price Swaps** | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **           | ** ** | ** **          | ** ** |
| ** **                                                        | ** ** | **(Bbls)**  | ** ** | **(per Gallon)**     | ** ** | ** **          | ** ** |
| October 2007 –  September 2008                          |       | 441,768     |       | $                    | 1.29       |                | (2,697     | ) |
| October 2008 –  December 2008                                |       | 110,442     |       | $                    | 1.31       |                | (347       | ) |
|                                                              |       |        |       |                 |       | $                   | (3,044)    |   |

 

**Note 6: Long-Term Debt**

 

| ** **                                         | ** ** | **As of  September 30,  2007** | ** ** | **As of  December 31,  2006** | ** ** |
|----------------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|
| Hiland Holdings  - Credit Facility                 |       | $                                        | 355        |                                    | $          | 254 |   |
| Hiland Partners  - Credit Facility                 |       | 201,064                                  |       | 147,064                                 |       |
| Capital lease  obligations                         |       | 5,703                                    |       | —                                  |       |
|                                               |       | 207,122                                  |       | 147,318                                 |       |
| Less: current  portion of capital lease obligation |       | 514                                      |       | —                                  |       |
| Long-Term Debt                                     |       | $                                        | 206,608    |                                    | $          | 147,318 |   |

 

***Hiland Holdings***

 

 On September 25, 2006, concurrently withthe closing of our initial public offering, the Partnership entered into athree-year $25.0 million secured revolving credit facility. The facilitywill permit us, if certain conditions are met, to increase borrowing capacity

 

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by up to an additional $25.0 million. The facility is secured by all ofour ownership interests in Hiland Partners and its general partner, other thanthe 2% general partner interest and the incentive distribution rights. Thefacility will mature on September 25, 2009 at which time all outstandingamounts thereunder become due and payable.

 

Indebtedness under thefacility bears interest, at our option, at either (i) an alternate baserate plus an applicable margin ranging from 100 to 150 basis points per annumor (ii) LIBOR plus an applicable margin ranging from 200 to 250 basispoints per annum in each case based on our ratio of consolidated funded debt toEBITDA. The alternate base rate is equal to the greatest of (a) the primerate in effect on such day, (b) the base CD rate in effect on such dayplus 1.50% and (c) the federal funds effective rate in effect on such dayplus 1/2 of 1%. A letter of credit fee will be payable for the aggregate amountof letters of credit issued under the facility at a percentage per annum equalto 2.0%. A commitment fee ranging from 25 to 50 basis points per annum based onour ratio of consolidated funded debt to EBITDA will be payable on the averagedaily unused portion of the facility for the quarter most recently ended. AtSeptember 30, 2007, the interest rate on outstanding borrowings from our creditfacility was 7.80%.

 

The facility containsseveral covenants that, among other things, require the maintenance of twofinancial performance ratios, restrict the payment of distributions tounitholders, and require financial reports to be submitted periodically to thefinancial institutions. The credit facility also contains covenants requiring amaximum consolidated funded debt to EBITDA ratio of 3.0:1.0 for the four fiscalquarters most recently ended and a minimum interest coverage ratio of 3.0:1.0.

 

The amount we may borrowunder the facility is limited to the lesser of: (i) 50% of the sum of thevalue of the Hiland Partners common and subordinated units and certain otherassets held by us and certain of our subsidiaries at the end of each fiscalquarter and (ii) the maximum available amount of the facility (currently$25.0 million).

 

The facility prohibits usfrom making distributions to unitholders if any default or event of default, asdefined in the credit facility, has occurred and is continuing or would resultfrom the distribution. In addition, the facility contains various covenantsthat limit, among other things, subject to certain exceptions and negotiated “baskets,”our ability to incur indebtedness, grant liens, enter into agreementsrestricting our ability to grant liens on our assets or amend the facility,make certain loans, acquisitions and investments or enter into a merger,consolidation or sale of assets.

 

The facility limitsdistributions to our unitholders to our available cash, as defined in ourpartnership agreement. Restricted payments under the facility are subject to anannual “clean-down” period of 15 consecutive days in which the amountoutstanding that relates to funding the restricted payments under the facilitymust be reduced to zero.

 

As of September 30, 2007,we had $0.4 million outstanding under this credit facility and were incompliance with our financial covenants.

 

***Hiland Partners***

 

*Credit Facility.*OnJuly 13, 2007, Hiland Partners entered into a third amendment to its creditfacility dated as of February 15, 2005. Pursuant to the amendment, HilandPartners may, among other things, increase its borrowing base from $200 millionto $250 million and decrease the accordion feature in the facility from $150million to $100 million.

 

The third amendmentincreased Hiland Partners’ borrowing capacity under its senior securedrevolving credit facility to $250 million such that the facility now consistsof a $241 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 distribution (the “Working Capital Facility”).

 

In addition, the thirdamendment provides for an accordion feature, which permits Hiland Partners ifcertain conditions are met, to increase the size of the Acquisition Facility byup to $100 million and allows for the issuance of letters of credit of up to$15 million in the aggregate.  The senior secured revolving creditfacility also requires Hiland 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.

 

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) an alternate base rate plus an applicable margin ranging from 50 to125 basis points per annum or (ii) LIBOR plus an applicable margin rangingfrom 150 to 225 basis points per annum based on our ratio of consolidatedfunded debt to EBITDA. The Alternate Base Rate is a rate per annum equal to thegreatest of (a) the Prime Rate in effect on such day, (b) the base CDrate in effect on such day plus 1.50% and (c) the Federal Funds effectiverate in effect on such day plus 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 1.0%. An unused commitment fee ranging from25 to 50 basis points per annum based on our ratio of consolidated funded debtto EBITDA will be payable on the unused portion of the credit

 

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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 September 30, 2007, the interest rate on outstanding borrowings fromHiland Partners’ credit facility was 7.75%.

 

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,” our ability to incurindebtedness, grant liens, make certain loans, acquisitions and investments,make any material changes to the nature of its business, amend its materialagreements, including its Omnibus Agreement, which contains non-compete andindemnity provisions with affiliates, or enter into a merger, consolidation orsale of assets.

 

The credit facility alsocontains covenants requiring Hiland Partners to maintain a maximum consolidatedfunded debt to EBITDA ratio of 4.0:1.0, provided that in the event HilandPartners makes certain permitted acquisitions or capital expenditures, thecredit facility allows this ratio to increase to 4.75:1.0 for the followingthree fiscal quarters (a “step-up period”) and a minimum interest coverageratio of 3.0:1.0.

 

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

 

Upon 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 September 30, 2007,Hiland Partners had $201.1 million outstanding under this credit facilityand was in compliance with its financial covenants.

 

*Capital Lease Obligation.*During the three months ended September 30, 2007, Hiland Partners incurred a$4,836 capital lease obligation at its Bakken gathering system resulting from aNGLs marketing agreement with a business partner whereby they have constructeda rail loading facility and a products pipeline, and Hiland Partners has agreedto repay the business partner a predetermined amount over a period of eightyears. As specified in the agreement, once fully paid, title to the railloading facility and a products pipeline will transfer to Hiland Partners nolater than the end of the eight year period.

 

In order to supplyadequate electric power supply to Hiland Partners new nitrogen rejection plantat it Badlands gathering system, Hiland Partners incurred a $1,045 capitallease obligation for the aid to construction of several electric substationswhich, by agreement, will be paid in equal monthly installments over a periodof five years.

 

During the three and ninemonths ended September 30, 2007, Hiland Partners made principal payments of$178 on the above described capital lease obligations. The current portion ofthe capital lease obligations presented in the table above is included inaccrued liabilities and other in the balance sheet.

 

***Hiland Partners GP, LLC***

 

 On May 1, 2006, Hiland Partners GP, LLCentered into an unsecured credit agreement under which it borrowed $35.0million to purchase 761,714 common units and 15,545 general partner units fromHiland Partners. The loan was guaranteed by all Hiland Partners GP, LLC’smembers and matured and was paid in full upon the completion of our initialpublic offering on September 25, 2006. Hiland Partners GP, LLC’s board ofdirectors, as well as the conflicts committee of its board of directors,consisting of independent directors, approved the transaction.

 

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**Note 7: Commitmentsand Contingencies**

 

Hiland Partners hasexecuted various natural gas fixed price physical forward sales contracts onapproximately 115,000 MMBtu per month for 2007 and 100,000 MMBtu per month for2008 with fixed prices ranging from $4.49 to $9.13 per MMBtu in 2007 and $8.43per MMBtu in 2008. These contracts have been designated as normal sales underSFAS No. 133 and are therefore not marked to market as derivatives. Asummary of the fixed price physical forward sales contracts is presented in thetable below:

 

| ** **                              | ** ** | ** **  | ** ** | **Average**          | ** ** |
|-----------------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                              | ** ** | ** **  | ** ** | **Fixed Price** | ** ** |
| **Production Period**              | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** |
|                                    |       |        |       |                 |       |
| October 2007 -  September 2008     |       | 1,245,000   |       | $                    | 8.01       |   |
|                                    |       |        |       |                 |       |
| October 2008  - December 2008 |       | 300,000     |       | $                    | 8.43       |   |

 

We maintain a definedcontribution retirement plan for our employees under which we makediscretionary contributions to the plan based on a percentage of eligibleemployees’ compensation. Contributions to the plan are 5.0% of eligibleemployees’ compensation and resulted in expense for the three months endedSeptember 30, 2007 and 2006 of $65 and $55, respectively and expense for thenine months ended September 30, 2007 and 2006 was $193 and $141, respectively.

 

Prior to January 1, 2007,we jointly participated with other affiliated companies in a self-insurancepool (the “Pool”) covering health and workers’ compensation claims made byemployees up to the first $150 and $500, respectively, per claim. Any amountspaid above these were reinsured through third party providers. Premiums chargedto us were based on estimated costs per employee of the Pool. Effective January1, 2007, we obtained our own health and workers’ compensation insurance throughthird-party providers Property and general liability insurance is alsomaintained through third-party providers with 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.Management believes that compliance with federal, state or local environmentallaws and regulations will not have a material adverse effect on our 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 leasesoffice space from a related entity (Please read Note 9). Hiland Partners alsoleases certain facilities, compressors, vehicles and other equipment underoperating leases, most of which contain annual renewal options. Under theselease agreements, rent expense was $532 and $283, for the three months endedSeptember 30, 2007 and 2006, respectively and $,1541 and $725 for the ninemonths ended September 30, 2007 and 2006, respectively.

 

**Note 8: SignificantCustomers 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  September 30,** | ** ** | **For the Nine  Months Ended  September 30,** | ** ** |
|------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** ** | ** ** | **2007**                                                           | ** ** | **2006**                                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Customer 1 |       | 19                                                                 | %          | 14                                                                | %          | 17 | % | 14 | % |
| Customer 2 |       | 15                                                                 | %          | 5                                                                 | %          | 13 | % | 3 | % |
| Customer 3 |       | 11                                                                 | %          | 3                                                                 | %          | 8 | % | 4 | % |
| Customer 4 |       | 9                                                                  | %          | 8                                                                 | %          | 9 | % | 8 | % |
| Customer 5 |       | 9                                                                  | %          | 11                                                                | %          | 20 | % | 17 | % |

 

19

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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  September 30,** | ** ** | **For the Nine  Months Ended  September 30,** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                                           | ** ** | **2006**                                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
| Supplier 1  (affiliated company) |       | 32                                                                 | %          | 33                                                                | %          | 29 | % | 34 | % |
| Supplier 2                       |       | 25                                                                 | %          | 23                                                                | %          | 26 | % | 24 | % |
| Supplier 3                       |       | 13                                                                 | %          | 13                                                                | %          | 14 | % | 13 | % |

 

**Note 9: RelatedParty Transactions**

 

Hiland Partners purchasesnatural gas and NGLs from affiliated companies. Purchases of product fromaffiliates totaled $14.5 million and $13.1 million for the three monthsended September 30, 2007 and 2006, respectively. Purchases of product fromaffiliates totaled $39.3 million and $39.6 million for the nine monthsended September 30, 2007 and 2006, respectively. Hiland Partners also sellsnatural gas and NGLs to affiliated companies. Sales of product to affiliatestotaled $0.7 million and $0.9 million for the three months ended September30, 2007 and 2006, respectively. Sales of product to affiliates totaled $2.4million and $3.2 million for the nine months ended September 30, 2007 and2006, respectively. Compression revenues from affiliates were $1.2 million foreach of the three months ended September 30, 2007 and 2006 and $3.6 million foreach of the nine months ended September 30, 2007 and 2006.

 

Accountsreceivable-affiliates of $905 at September 30, 2007 include $834 from oneaffiliate for midstream sales. Accounts receivable-affiliates of $1,284 atDecember 31, 2006, include $1,260 from one affiliate for midstream sales.

 

Accountspayable-affiliates of $5,087 at September 30, 2007 include $4,676 due to oneaffiliate for midstream purchases. Accounts payable-affiliates of $4,412 atDecember 31, 2006 include $3,819 payable to the same affiliate formidstream purchases

 

Hiland Partners utilizesaffiliated companies to provide services to its plants and pipelines andcertain administrative services. The total amount paid to these companies was $78and $64 during the three months ended September 30, 2007 and 2006,respectively. Amounts paid to these companies during the nine months endedSeptember 30, 2007 and 2006 totaled $352 and $180, respectively.

 

Hiland Partners leasesoffice space under operating leases directly or indirectly from an affiliate.Rents paid associated with these leases totaled $38 and $32 for the threemonths ended September 30, 2007 and 2006, respectively. Rents paid associatedwith these leases totaled $140 and $86 for the nine months ended September 30,2007 and 2006, respectively.

 

**Note 10: ReportableSegments**

 

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 gathering, compressing, dehydrating, treating andprocessing of natural gas and fractionating NGLs.

 

(2)  Compression which is providing air compression and water injection services forContinental Resources, Inc.’s oil and gas secondary recovery operationsthat are ongoing in North Dakota.

 

These segments reflectthe way Hiland Partners manages its operations. Hiland Partners’ operations areconducted in the United States. General and administrative costs, which consistof executive management, accounting and finance, operations and engineering,marketing and business development, are allocated to the individual segmentsbased on revenues.

 

Midstream assets totaled$374,317 at September 30, 2007. Assets attributable to compression operationstotaled $28,714. All but $16 of the total capital expenditures of $73,318 forthe nine months ended September 30, 2007 was attributable to midstreamoperations.

 

20

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The tables below presentinformation for the reportable segments for the three and nine months endedSeptember 30, 2007 and 2006.

 
| ** **                                                       | ** ** | **For the Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2007**                                                                   | ** ** | **2006** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                              | ** ** | **Compression** | ** ** | **Total** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | **Total** | ** ** |
| Revenues                                                         |       | $                                                                          | 66,431     |   | $ | 1,205 |   | $ | 67,636 |   | $ | 56,062 |   | $ | 1,205 |   | $ | 57,267 |   |
| Operating costs  and expenses:                                   |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 45,789                                                                     |       | — |   | 45,789 |   | 39,609 |   | — |   | 39,609 |   |
| Operations and  maintenance                                      |       | 5,913                                                                      |       | 244 |   | 6,157 |   | 4,367 |   | 202 |   | 4,569 |   |
| Depreciation and  amortization                                   |       | 6,975                                                                      |       | 895 |   | 7,870 |   | 5,569 |   | 893 |   | 6,462 |   |
| General and  administrative expenses                             |       | 2,017                                                                      |       | 37 |   | 2,054 |   | 1,368 |   | 29 |   | 1,397 |   |
| Total operating  costs and expenses                              |       | 60,694                                                                     |       | 1,176 |   | 61,870 |   | 50,913 |   | 1,124 |   | 52,037 |   |
| Operating income                                                 |       | $                                                                          | 5,737      |   | $ | 29 |   | 5,766 |   | $ | 5,149 |   | $ | 81 |   | 5,230 |   |
| Other income  (expense):                                         |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest and  other income                                       |       |                                                                       |       |   |   | 105 |   |   |   |   |   | 68 |   |
| Amortization of  deferred loan costs                             |       |                                                                       |       |   |   | (136 | ) |   |   |   |   | (170 | ) |
| Interest expense                                                 |       |                                                                       |       |   |   | (3,133 | ) |   |   |   |   | (2,387 | ) |
| Minority  interest in income of Hiland Partners, LP              |       |                                                                       |       |   |   | (867 | ) |   |   |   |   | (2,765 | ) |
| Net income  (loss)                                               |       |                                                                       |       |   |   | $ | 1,735 |   |   |   |   |   | $ | (24 | ) |

 
| ** **                                                       | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2007**                                                                  | ** ** | **2006** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                             | ** ** | **Compression** | ** ** | **Total** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | **Total** | ** ** |
| Revenues                                                         |       | $                                                                         | 191,691    |   | $ | 3,615 |   | $ | 195,306 |   | $ | 159,800 |   | $ | 3,615 |   | $ | 163,415 |   |
| Operating costs  and expenses:                                   |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 137,320                                                                   |       | — |   | 137,320 |   | 117,965 |   | — |   | 117,965 |   |
| Operations and  maintenance                                      |       | 15,499                                                                    |       | 609 |   | 16,108 |   | 10,509 |   | 631 |   | 11,140 |   |
| Depreciation and  amortization                                   |       | 19,539                                                                    |       | 2,683 |   | 22,222 |   | 13,577 |   | 2,679 |   | 16,256 |   |
| General and  administrative expenses                             |       | 6,265                                                                     |       | 118 |   | 6,383 |   | 3,614 |   | 81 |   | 3,695 |   |
| Total operating  costs and expenses                              |       | 178,623                                                                   |       | 3,410 |   | 182,033 |   | 145,665 |   | 3,391 |   | 149,056 |   |
| Operating income                                                 |       | $                                                                         | 13,068     |   | $ | 205 |   | 13,273 |   | $ | 14,135 |   | $ | 224 |   | 14,359 |   |
| Other income  (expense):                                         |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest and  other income                                       |       |                                                                      |       |   |   | 325 |   |   |   |   |   | 221 |   |
| Amortization of  deferred loan costs                             |       |                                                                      |       |   |   | (357 | ) |   |   |   |   | (402 | ) |
| Interest expense                                                 |       |                                                                      |       |   |   | (7,538 | ) |   |   |   |   | (4,649 | ) |
| Minority  interest in income of Hiland Partners, LP              |       |                                                                      |       |   |   | (2,080 | ) |   |   |   |   | (8,991 | ) |
| Net income                                                       |       |                                                                      |       |   |   | $ | 3,623 |   |   |   |   |   | $ | 538 |   |

 

**Note 11: NetIncome per Limited Partners’ Unit**

 

The computation of basicnet income per limited partner unit is based on the weighted-average number ofcommon units outstanding during the period. The computation of diluted earningsper unit further assumes the dilutive effect of restricted units. Net incomeper unit applicable to limited partners is computed by dividing net incomeapplicable to limited partners by the weighted-average number of limitedpartnership units outstanding. The following is a reconciliation of the limitedpartner units used in the calculations of income per limited partner unit—basicand income per limited partner unit—diluted assuming dilution for the three andnine months ended September 30, 2007and 2006:

 

21

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| ** **                                          | ** ** | **For the Three Months Ended September 30,** | ** ** | **For the Three Months Ended September 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                                                   | ** ** | **2006**                                                                   | ** ** |
| ** **                                          | ** ** | **Income  Available to  Limited  Partners  (Numerator)**              | ** ** | **Limited  Partner Units  (Denominator)**                             | ** ** | **Per Unit  Amount** | ** ** | **Income  Available to  Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** |
| Income per  limited partner unit—basic:        |       |                                                                       |       |                                                                       |       |   |   |   |   |   |   |   |   |
| Income available  to limited unitholder             |       | $                                                                          | 1,735      |                                                                       |       |   | $ | 0.08 |   | $ | 131 |   |   |   | $ | 0.01 |   |
| Weighted average  limited partner units outstanding |       |                                                                       |       | 21,600                                                                     |       |   |   |   |   | 21,600 |   |   |   |
| Income per  limited partner unit—diluted:      |       |                                                                       |       |                                                                       |       |   |   |   |   |   |   |   |   |
| Restricted units                                    |       |                                                                       |       | 9                                                                          |       |   |   |   |   | — |   |   |   |
| Income available  to common unitholders             |       | $                                                                          | 1,735      |                                                                       | 21,609     |   | $ | 0.08 |   | $ | 131 |   | 21,600 |   | $ | 0.01 |   |

 
| ** **                                          | ** ** | **For the Nine Months  Ended September 30,** | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                                                        | ** ** | **2006**                                                                  | ** ** |
| ** **                                          | ** ** | **Income  Available to  Limited  Partners  (Numerator)**                   | ** ** | **Limited  Partner Units  (Denominator)**                            | ** ** | **Per Unit  Amount** | ** ** | **Income  Available to  Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** |
| Income per  limited partner unit—basic:        |       |                                                                            |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Income available  to limited unitholder             |       | $                                                                               | 3,623      |                                                                      |       |   | $ | 0.17 |   | $ | 131 |   |   |   | $ | 0.01 |   |
| Weighted average  limited partner units outstanding |       |                                                                            |       | 21,600                                                                    |       |   |   |   |   | 21,600 |   |   |   |
| Income per  limited partner unit—diluted:      |       |                                                                            |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Restricted units                                    |       |                                                                            |       | 10                                                                        |       |   |   |   |   | — |   |   |   |
| Income available  to common unitholders             |       | $                                                                               | 3,623      |                                                                      | 21,610     |   | $ | 0.17 |   | $ | 131 |   | 21,600 |   | $ | 0.01 |   |

 

**Note 12: Owners’Capital 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 our partnershipagreement, which provides that any units held by a person that owns 20% or moreof any class of units then outstanding, other than the general partner, itsaffiliates, their transferees and persons who acquired such units with theprior approval of the board of directors of our general partner, cannot bevoted on any matter. In addition, our partnership agreement contains provisionslimiting the ability of our unitholders to call meetings or to acquireinformation about our operations, as well as other provisions limiting aunitholders’ 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 quarterless reserves established at our general partner’s discretion. We refer to thisas “available cash.” Initially our only cash-generating assets are ourinterests in Hiland Partners from which we receive quarterly distributions. Theamount of available cash may be greater than or less than the minimum quarterlydistributions.

 

22

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All distributions paid byHiland Holdings to common unitholders, including amounts paid to affiliateowners were as follows (in thousands, except per unit amounts):

 

| **Date Cash Distribution Paid** | ** ** | **Per Unit Cash  Distribution  Amount** | ** ** | **Total Cash  Distribution** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------------------|------------|
| 02/19/07                                       |       | $                                                 | 0.0132     |                              | $          | 285 |   |
| 02/19/07                                       |       | 0.2075                                            |       | 4,484                             |       |
| 05/18/07                                       |       | 0.2075                                            |       | 4,485                             |       |
| 08/17/07                                       |       | 0.2200                                            |       | 4,755                             |       |
| 11/19/07 (a)                                   |       | 0.2300                                            |       | 4,972                             |       |
|                                           |       | $                                                 | 0.8782     |                              | $          | 18,981 |   |

 

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(a)      Thiscash distribution was announced on October 25, 2007 and will be paid onNovember 19, 2007 to all unitholders of record as of November 6,2007.

 

***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. We refer to this as “available cash.” The amount of available cashmay be greater than or less than the minimum quarterly distributions describedbelow. In general, Hiland Partners will pay any cash distribution made eachquarter in the following manner:

 

•    first, 98% to the common units and 2%to our general partner, until each common unit has received a minimum quarterlydistribution of $0.45 plus any arrearages from prior quarters;

 

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

 

•    third,98% to all units pro rata, and 2% to our general partner, 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. We refer to these distributionsas “incentive distributions.”

 

The distributions on thesubordinated units may be reduced or eliminated if necessary to ensure thecommon units receive their minimum quarterly distribution. Subordinated unitswill not accrue arrearages. The subordination period will end once HilandPartners meets certain financial tests, but not before March 31, 2010.These financial tests require Hiland Partners to have earned and paid theminimum quarterly distribution on all of its outstanding units for threeconsecutive four-quarter periods. When the subordination period ends, all remainingsubordinated units will convert into common units on a one-for-one basis andthe common units will no longer be entitled to arrearages. As of September 30,2007, we own 4,080,000 subordinated units, which is all of, Hiland Partners’subordinated units.

 

23

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Presented below are cashdistributions to Hiland Partners, common and subordinated unitholders,including amounts to affiliate owners and regular and incentive distributionsto Hiland Partners GP, LLC paid by Hiland Partners from January 1, 2006 forward(in thousands, except per unit amounts):

 
| ** **                                     | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| ** **                                     | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Date Cash Distribution Paid** | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
| 02/14/06                                       |       | $                           | 0.6250     |       | $          | 2,724            |       | $                        | 2,550      |                | $          | 112              |       | $ | 249 |   | $ | 5,635 |   |
| 05/15/06                                       |       | 0.6500                      |       | 2,858      |       | 2,652            |       | 119                      |       | 315                 |       | 5,944            |       |
| 08/14/06                                       |       | 0.6750                      |       | 3,485      |       | 2,754            |       | 136                      |       | 414                 |       | 6,789            |       |
| 11/14/06                                       |       | 0.7000                      |       | 3,623      |       | 2,856            |       | 145                      |       | 637                 |       | 7,261            |       |
| 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 (a)                                   |       | 0.7550                      |       | 3,959      |       | 3,080            |       | 167                      |       | 1,134               |       | 8,340            |       |
|                                           |       | $                           | 5.5625     |       | $          | 27,904           |       | $                        | 22,695     |                | $          | 1,138            |       | $ | 5,182 |   | $ | 56,919 |   |

 

----

(a)   This cashdistribution was announced on October 25, 2007 and will be paid onNovember 14, 2007 to all unitholders of record as of November 6, 2007.

 

Presented below are cashdistributions by Hiland Partners to us and Hiland Partners GP, LLC from January1, 2006 forward (in thousands, except per unit amounts):

 
| ** **                                     | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| ** **                                     | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Date Cash Distribution Paid** | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
| 02/14/06                                       |       | $                           | 0.6250     |       | $          | —           |       | $                        | —     |                | $          | 112              |       | $ | 249 |   | $ | 361 |   |
| 05/15/06                                       |       | 0.6500                      |       | —     |       | —           |       | 119                      |       | 315                 |       | 434              |       |
| 08/14/06                                       |       | 0.6750                      |       | 514        |       | —           |       | 136                      |       | 414                 |       | 1,064            |       |
| 11/14/06                                       |       | 0.7000                      |       | 557        |       | 186              |       | 145                      |       | 637                 |       | 1,525            |       |
| 02/14/07                                       |       | 0.7125                      |       | 927        |       | 2,907            |       | 150                      |       | 749                 |       | 4,733            |       |
| 5/15/07                                        |       | 0.7125                      |       | 927        |       | 2,907            |       | 151                      |       | 752                 |       | 4,737            |       |
| 8/14/07                                        |       | 0.7325                      |       | 953        |       | 2,989            |       | 158                      |       | 932                 |       | 5,032            |       |
| 11/14/07 (a)                                   |       | 0.7550                      |       | 983        |       | 3,080            |       | 167                      |       | 1,134               |       | 5,364            |       |
|                                           |       | $                           | 5.5625     |       | $          | 4,861            |       | $                        | 12,069     |                | $          | 1,138            |       | $ | 5,182 |   | $ | 23,250 |   |

 

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(a)   This cashdistribution was announced on October 25, 2007 and will be paid on November 14,2007 to all unitholders of record as of November 6, 2007.

 

24

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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.

 

**CautionaryStatement About Forward-Looking Statements**

 

This quarterly report onForm 10-Q includes certain “forward-looking statements” within the meaningof Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. These statements include statements regardingour plans, goals, beliefs or current expectations. Statements using words suchas “anticipate,” “believe,” “intend,” “project,” “plan,” “continue,” “estimate,”“forecast,” “may,” “will,” or similar expressions help identify forward-lookingstatements. Although we believe such forward-looking statements are based onreasonable assumptions and current expectations and projections about futureevents, no assurance can be given that every objective will be reached.

 

Actual results may differmaterially from any results projected, forecasted, estimated or expressed inforward-looking statements since many of the factors that determine theseresults are subject to uncertainties and risks, difficult to predict, andbeyond management’s control. Such factors include:

 

•      ourability to pay distributions to our unitholders;

 

•      ourexpected receipt of distributions from Hiland Partners;

 

•     the general economic conditions in the United States of America as well as thegeneral economic conditions and currencies in foreign countries;

 

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

 

•      theamount of natural gas transported on Hiland Partners’ gathering systems;

 

•      thelevel of throughput in Hiland Partners’ natural gas processing and treatingfacilities;

 

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

 

•      the pricesand market demand for, and the relationship between, natural gas and naturalgas liquids, or (NGLs);

 

•      energyprices generally;

 

•      thelevel of domestic oil and natural gas production;

 

•      theavailability of imported oil and natural gas;

 

•      actionstaken by foreign oil and gas producing nations;

 

•      thepolitical and economic stability of petroleum producing nations;

 

•      theweather in Hiland Partners’ operating areas;

 

•      theextent of governmental regulation and taxation;

 

•     hazards or operating risks incidental to the transporting, treating andprocessing of natural gas and NGLs that may not be fully covered by insurance;

 

•     competition from other midstream companies;

 

•      loss ofkey personnel;

 

•      theavailability and cost of capital and Hiland Partners’ ability to access certaincapital sources;

 

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

 

•      thecosts and effects of legal and administrative proceedings;

 

•     the ability to successfully identify and consummate strategic acquisitions atpurchase prices that are accretive to the Hiland Partners’ financial results;and

 

•     risks associated with the construction of new pipelines and treating andprocessing facilities or additions to Hiland Partners’ existing pipelines andfacilities.

 

25

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

 

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.

 

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

 

**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’ interestsin Hiland Partners’ net income.

 

Our cash generatingassets consist of our direct or indirect ownership interests in HilandPartners. Hiland Partners is principally engaged in gathering, compressing,dehydrating, treating, processing and marketing natural gas, fractionatingnatural gas liquids and providing air compression and water injection servicesfor oil and gas secondary recovery operations. Our aggregate ownershipinterests in Hiland Partners consist of the following:

 

•      the 2%general partner interest in Hiland Partners;

 

•      100% ofthe incentive distribution rights in Hiland Partners; and

 

•     1,301,471 common units and 4,080,000 subordinated units of Hiland Partners,representing a 57.8% limited partner interest 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 $0.7550 per unit for thequarter ended September 30, 2007. This distribution will be paid onNovember 14, 2007 to unitholders of record on November 6, 2007.

 

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 Hiland Partners through the use of ourcapital resources, which could involve loans or capital contributions to HilandPartners to provide funding for the acquisition of a business or an asset orfor an internal growth project. In addition, we may provide Hiland Partnerswith other forms of credit support, such as guarantees relating to financing aproject or other types of support related to a merger or acquisitiontransaction.

 

Cash Distributions.  The following table sets forth the distributions that we have received fromHiland Partners during the periods indicated.

 

| ** **                                                                      | ** ** | ** **                                               | ** ** | **Hiland Partners**                                | ** ** | ** **               | ** ** | **Hiland Partners** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                                                      | ** ** | **Hiland Holdings**                                 | ** ** | **GP, LLC**                                        | ** ** | **Hiland Holdings** | ** ** | **GP, LLC**         | ** ** |
| ** **                                                                      | ** ** | **GP, LP**                                          | ** ** | **(Predecessor)**                                       | ** ** | **GP, LP**          | ** ** | **(Predecessor)**        | ** ** |
| ** **                                                                      | ** ** | **Three Months Ended September 30,** | ** ** | **Nine months Ended September 30,** | ** ** |
| ** **                                                                      | ** ** | **2007 (a)**                                        | ** ** | **2006**                                                | ** ** | **2007 (a)**        | ** ** | **2006**                 | ** ** |
| Distributions  from Hiland Partners’ common units                          |       | $                                                        | 953        |                                                    | $          | —                   |       | $                        | 2,808      |   | $ | — |   |
| Distributions  from Hiland Partners’ subordinated units                    |       | 2,989                                                    |       | —                                                  |       | 8,803                    |       | —                   |       |
| Distributions  from ownership interest in Hiland Partners’ general partner |       | 158                                                      |       | 136                                                     |       | 459                      |       | 367                      |       |
| Distributions  from Hiland Partners’ incentive distribution rights         |       | 932                                                      |       | 414                                                     |       | 2,433                    |       | 978                      |       |
| Total                                                                           |       | $                                                        | 5,032      |                                                    | $          | 550                      |       | $                        | 14,503     |   | $ | 1,345 |   |

 

----

(a)  Because we ownHiland Partners GP, LLC the distributions to us include the distributions madeto Hiland Partners GP, LLC and to us from September 25, 2006 forward.

 

26

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**Overviewof Hiland Partners**

 

Hiland Partners isengaged in gathering, compressing, dehydrating, treating, processing andmarketing natural gas, fractionating NGLs and providing air compression andwater injection services for oil and gas secondary recovery operations. HilandPartners’ operations are primarily located in the Mid-Continent and RockyMountain 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:

 

• *Midstream Segment,* which is engaged in gathering and processing ofnatural gas primarily in the Mid-Continent and Rocky Mountain regions. Withinthis segment, Hiland Partners also provides certain related services forcompression, dehydrating, and treating of natural gas and the fractionation ofNGLs. The midstream segment generated 94.5% and 93.2% of total segment marginfor the three months ended September 30, 2007 and 2006, respectively, and 93.8%and 92.0% of total segment margin for the nine months ended September 30, 2007and 2006.

 

• *Compression Segment,* which is engaged in providing air compressionand water injection services for oil and gas secondary recovery operations thatare ongoing in North Dakota. The compression segment generated 5.5% and 6.8% oftotal segment margin for the three months ended September 30, 2007 and 2006,respectively, and 6.2% and 8.0% of total segment margin for the nine monthsended September 30, 2007 and 2006, respectively.

 

Hiland Partners’midstream assets currently consist of 13 natural gas gathering systems withapproximately 1,934 miles of gas gathering pipelines, five natural gasprocessing plants, seven natural gas treating facilities and three NGLfractionation facilities. Hiland Partners’ compression assets consist of twoair compression facilities and a water injection plant.

 

Hiland Partners’ resultsof operations are determined primarily by five interrelated variables:(1) the volume of natural gas gathered through its pipelines; (2) thevolume of natural gas processed; (3) the volume of NGLs fractionated;(4) the levels and relationship of natural gas and NGL prices; and(5) Hiland Partners’ current contract portfolio. Because Hiland Partners’profitability is a function of the difference between the revenues it receivesfrom its operations, including revenues from the products it sells, and thecosts associated with conducting its operations, including the costs ofproducts it purchases, increases or decreases in Hiland Partners’ revenuesalone are not necessarily indicative of increases or decreases in itsprofitability. To a large extent, Hiland Partners’ contract portfolio and thepricing environment for natural gas and NGLs will dictate increases ordecreases in its profitability. Hiland Partners’ profitability is alsodependent upon prices and market demand for natural gas and NGLs, whichfluctuate with changes in market and economic conditions and other factors.

 

**RecentEvents**

 

*Badlands Gathering System.*During the third quarter 2007, HilandPartners completed the expansion of its Badlands gathering system, theassociated field gathering infrastructure and processing plant, which includedthe completion of a 40,000 Mcf/d nitrogen rejection plant. As a result, gatheringpipelines, processing plant, treating facility and fractionation facilitythroughput capacities have increased significantly on the Badlands gatheringsystem.

 

*Bakken Gathering System*.During the third quarter 2007, Hiland Partners completed the expansion of theexisting NGL fractionation facility at the Bakken processing plant enabling itto fractionate increased NGL volumes from both the Bakken processing plant andthe Badlands processing plant. Additionally, during the second quarter 2007, constructionwas completed on a rail terminal which will allow transportation of NGL volumesnot only by truck, but also by rail, thereby penetrating additional salesmarkets. The pipeline to the rail terminal was completed early in the thirdquarter 2007.

 

On July 13, 2007, HilandPartners completed a third amendment to its existing credit agreement toincrease its borrowing base by $50 million from $200 million to $250 million.

 

*Woodford Shale Gathering System.*During the second quarter 2007, Hiland Partners connected the first wellrelated to an agreement with Continental Resources, Inc. to construct andoperate gathering pipelines and related facilities associated with thedevelopment of acreage owned by Continental Resources, Inc. in the WoodfordShale Play in the Arkoma Basin of southeastern Oklahoma. The gathering systemis being designed to provide low-pressure and highly reliable gathering,compression, dehydration, and processing services. When completed, thegathering infrastructure is expected to include more than 15,500 horsepower ofcompression to provide takeaway capacity in excess of 40,000 Mcf/d.

 

On June 19, 2007, Mr.Joseph L. Griffin was appointed Chief Executive Officer, President and adirector of our general partner. Mr. Griffin replaced Mr. Randy Moeder, whoresigned on April 16, 2007.

 

**HistoricalResults of Operations**

 

Our historical results ofoperations for the periods presented may not be comparable, either from periodto period or going forward, for the reasons described below.

 

27

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Our historical financialinformation for periods prior to September 25, 2006 reflects the financialresults of Hiland Partners GP, LLC, our predecessor. Accordingly, thediscussion of our financial position and results of operations in this “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”reflects the operating activities and results of operations of us beginningSeptember 25, 2006.

 

Hiland Partnersacquisition of the Kinta Area gathering assets from Enogex Gas Gathering,L.L.C. on May 1, 2006 was accounted for as a purchase of assets.  Resultsof operations from the Kinta Area gathering assets are only reflected from May1, 2006.

 

**Resultsof Operations**

 

The results of our operationsdiscussed below principally reflect the activities of Hiland Partners. Becauseour consolidated financial statements include the results of Hiland Partners,our financial statements are substantially similar to the financial statementsof Hiland Partners. However, our consolidated balance sheet includes a minorityinterest amount that reflects the proportion of Hiland Partners owned by itsunitholders other than us. Similarly, the ownership interests in HilandPartners held by its unitholders other than us are reflected in ourconsolidated income statement as minority interest. The minority interestamounts are not reflected on Hiland Partners’ financial statements.

 

Set forth in the tablesbelow are financial and operating data for us and our predecessor, HilandPartners GP, LLC for the periods indicated.

 
| ** **                                                       | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2007**                                                 | ** ** | **2006** | ** ** |
| ** **                                                       | ** ** | ** **                                               | ** ** | ** ** | ** ** | **Hiland** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Hiland**                                               | ** ** | **Hiland** | ** ** | **Partners** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Holdings**                                             | ** ** | **Holdings** | ** ** | **GP, LLC** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **GP, LP**                                          | ** ** | **GP, LP (4)** | ** ** | **(Predecessor) (5)** | ** ** | **Total (6)** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**                                  | ** ** |
| **Total  Segment Margin Data:**                                  | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream  revenues                                              |       | $                                                        | 66,431     |   | $ | 3,656 |   | $ | 52,406 |   | $ | 56,062 |   |
| Midstream  purchases                                             |       | 45,789                                                   |       | 2,583 |   | 37,026 |   | 39,609 |   |
| Midstream  segment margin                                        |       | 20,642                                                   |       | 1,073 |   | 15,380 |   | 16,453 |   |
| Compression  revenues (1)                                        |       | 1,205                                                    |       | 79 |   | 1,126 |   | 1,205 |   |
| Total segment  margin (2)                                        |       | $                                                        | 21,847     |   | $ | 1,152 |   | $ | 16,506 |   | $ | 17,658 |   |
|                                                             |       |                                                     |       |   |   |   |   |   |   |
| **Summary  of Operations Data:**                                 | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream  revenues                                              |       | $                                                        | 66,431     |   | $ | 3,656 |   | $ | 52,406 |   | $ | 56,062 |   |
| Compression  revenues                                            |       | 1,205                                                    |       | 79 |   | 1,126 |   | 1,205 |   |
| Total revenues                                                   |       | 67,636                                                   |       | 3,735 |   | 53,532 |   | 57,267 |   |
|                                                             |       |                                                     |       |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 45,789                                                   |       | 2,583 |   | 37,026 |   | 39,609 |   |
| Operations and  maintenance                                      |       | 6,157                                                    |       | 298 |   | 4,271 |   | 4,569 |   |
| Depreciation,  amortization and accretion                        |       | 7,870                                                    |       | 427 |   | 6,035 |   | 6,462 |   |
| General and  administrative                                      |       | 2,054                                                    |       | 105 |   | 1,292 |   | 1,397 |   |
| Total operating  costs and expenses                              |       | 61,870                                                   |       | 3,413 |   | 48,624 |   | 52,037 |   |
| Operating income                                                 |       | 5,766                                                    |       | 322 |   | 4,908 |   | 5,230 |   |
| Other income  (expense)                                          |       | (3,164                                                   | )          | (119 | ) | (2,370 | ) | (2,489 | ) |
| Income before  minority interest in income of Hiland Partners    |       | 2,602                                                    |       | 203 |   | 2,538 |   | 2,741 |   |
| Minority  interest in income of Hiland Partners                  |       | (867                                                     | )          | (72 | ) | (2,693 | ) | (2,765 | ) |
| **Net  income (loss)**                                           |       | $                                                        | 1,735      |   | $ | 131 |   | $ | (155 | ) | $ | (24 | ) |
|                                                             |       |                                                     |       |   |   |   |   |   |   |
| Hiland Partners  operating data:                                 |       |                                                     |       |   |   |   |   |   |   |
| Inlet natural  gas (MCF/d)                                       |       | 219,544                                                  |       |   |   |   |   | 203.721 |   |
| Natural gas  sales (MMBTU/d)                                     |       | 84,281                                                   |       |   |   |   |   | 69,563 |   |
| NGL sales  (Bbls/d)                                              |       | 4,721                                                    |       |   |   |   |   | 3,239 |   |
| Natural gas  gathered (MMBtu/d) (3)                              |       | 124,121                                                  |       |   |   |   |   | 129,168 |   |

 

28

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| ** **                                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| ** **                                                       | ** ** | ** **                                              | ** ** | ** ** | ** ** | **Hiland** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Hiland**                                              | ** ** | **Hiland** | ** ** | **Partners** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Holdings**                                            | ** ** | **Holdings** | ** ** | **GP, LLC** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **GP, LP**                                         | ** ** | **GP, LP (4)** | ** ** | **(Predecessor) (5)** | ** ** | **Total (6)** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**                                 | ** ** |
| **Total  Segment Margin Data:**                                  | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream  revenues                                              |       | $                                                       | 191,691    |   | $ | 10,422 |   | $ | 149,378 |   | $ | 159,800 |   |
| Midstream  purchases                                             |       | 137,320                                                 |       | 7,693 |   | 110,272 |   | 117,965 |   |
| Midstream  segment margin                                        |       | 54,371                                                  |       | 2,729 |   | 39,106 |   | 41,835 |   |
| Compression  revenues (1)                                        |       | 3,615                                                   |       | 236 |   | 3,379 |   | 3,615 |   |
| Total segment  margin (2)                                        |       | $                                                       | 57,986     |   | $ | 2,965 |   | $ | 42,485 |   | $ | 45,450 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| **Summary  of Operations Data:**                                 | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream  revenues                                              |       | $                                                       | 191,691    |   | $ | 10,422 |   | $ | 149,378 |   | $ | 159,800 |   |
| Compression  revenues                                            |       | 3,615                                                   |       | 236 |   | 3,379 |   | 3,615 |   |
| Total revenues                                                   |       | 195,306                                                 |       | 10,658 |   | 152,757 |   | 163,415 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 137,320                                                 |       | 7,693 |   | 110,272 |   | 117,965 |   |
| Operations and maintenance                                       |       | 16,108                                                  |       | 727 |   | 10,413 |   | 11,140 |   |
| Depreciation,  amortization and accretion                        |       | 22,222                                                  |       | 1,054 |   | 15,202 |   | 16,256 |   |
| General and  administrative                                      |       | 6,383                                                   |       | 253 |   | 3,442 |   | 3,695 |   |
| Total operating  costs and expenses                              |       | 182,033                                                 |       | 9,727 |   | 139,329 |   | 149,056 |   |
| Operating income                                                 |       | 13,273                                                  |       | 931 |   | 13,428 |   | 14,359 |   |
| Other income  (expense)                                          |       | (7,570                                                  | )          | (247 | ) | (4,583 | ) | (4,830 | ) |
| Income before  minority interest in income of Hiland Partners    |       | 5,703                                                   |       | 684 |   | 8,845 |   | 9,529 |   |
| Minority  interest in income of Hiland Partners                  |       | (2,080                                                  | )          | (553 | ) | (8,438 | ) | (8,991 | ) |
| **Net  income**                                                  |       | $                                                       | 3,623      |   | $ | 131 |   | $ | 407 |   | $ | 538 |   |
|                                                             |       |                                                    |       |   |   |   |   |   |   |
| Hiland Partners  operating data:                                 |       |                                                    |       |   |   |   |   |   |   |
| Inlet natural  gas (MCF/d)                                       |       | 210,878                                                 |       |   |   |   |   | 143,112 |   |
| Natural gas  sales (MMBTU/d)                                     |       | 78,998                                                  |       |   |   |   |   | 64,796 |   |
| NGL sales  (Bbls/d)                                              |       | 4,340                                                   |       |   |   |   |   | 3,256 |   |
| Natural gas  gathered (MMBtu/d) (3)                              |       | 124,486                                                 |       |   |   |   |   | 72,657 |   |

 

----

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

(2)       Reconciliationof total segment margin to operating income:

 

| ** **                                                      | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2007**                                                 | ** ** | **2006** | ** ** |
| ** **                                                      | ** ** | ** **                                               | ** ** | ** ** | ** ** | **Hiland** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **Hiland**                                               | ** ** | **Hiland** | ** ** | **Partners** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **Holdings**                                             | ** ** | **Holdings** | ** ** | **GP, LLC** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **GP, LP**                                          | ** ** | **GP, LP (4)** | ** ** | **(Predecessor) (5)** | ** ** | **Total (6)** | ** ** |
| ** **                                                      | ** ** | **(in thousands)**                                  | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Income** |       |                                                     |       |   |   |   |   |   |   |
| Operating income                                                |       | $                                                        | 5,766      |   | $ | 322 |   | $ | 4,908 |   | $ | 5,230 |   |
| Add:                                                            |       |                                                     |       |   |   |   |   |   |   |
| Operations and  maintenance expenses                            |       | 6,157                                                    |       | 298 |   | 4,271 |   | 4,569 |   |
| Depreciation,  amortization and accretion                       |       | 7,870                                                    |       | 427 |   | 6,035 |   | 6,462 |   |
| General and  administrative expenses                            |       | 2,054                                                    |       | 105 |   | 1,292 |   | 1,397 |   |
| Total segment  margin                                           |       | $                                                        | 21,847     |   | $ | 1,152 |   | $ | 16,506 |   | $ | 17,658 |   |

 

29

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| ** **                                                      | ** ** | **Nine Months Ended September 30,** |       |
|-----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2007**                                                | ** ** | **2006** |   |
| ** **                                                      | ** ** | ** **                                              | ** ** | ** ** | ** ** | **Hiland** | ** ** | ** ** |   |
| ** **                                                      | ** ** | **Hiland**                                              | ** ** | **Hiland** | ** ** | **Partners** | ** ** | ** ** |   |
| ** **                                                      | ** ** | **Holdings**                                            | ** ** | **Holdings** | ** ** | **GP, LLC** | ** ** | ** ** |   |
| ** **                                                      | ** ** | **GP, LP**                                         | ** ** | **GP, LP (4)** | ** ** | **(Predecessor) (5)** | ** ** | **Total (6)** |   |
| ** **                                                      | ** ** | **(in thousands)**                                 |       |
| **Reconciliation  of Total Segment Margin to Operating Income** |       |                                                    |       |   |   |   |   |   |   |
| Operating income                                                |       | $                                                       | 13,273     |   | $ | 931 |   | $ | 13,428 |   | $ | 14,359 |   |
| Add:                                                            |       |                                                    |       |   |   |   |   |   |   |
| Operations and  maintenance expenses                            |       | 16,108                                                  |       | 727 |   | 10,413 |   | 11,140 |   |
| Depreciation,  amortization and accretion                       |       | 22,222                                                  |       | 1,054 |   | 15,202 |   | 16,256 |   |
| General and  administrative expenses                            |       | 6,383                                                   |       | 253 |   | 3,442 |   | 3,695 |   |
| Total segment  margin                                           |       | $                                                       | 57,986     |   | $ | 2,965 |   | $ | 42,485 |   | $ | 45,450 |   |

 

We view total segmentmargin, a non-GAAP financial measure, as a separate performance measure of thecore profitability of our operations. We review total segment margin monthlyfor a consistency and trend analysis. We define midstream segment margin asmidstream revenue less midstream purchases. Midstream purchases include thefollowing costs and expenses: cost of natural gas and NGLs purchased by us fromthird parties, cost of natural gas and NGLs purchased by us from affiliates,and the cost of crude oil purchased by us from third parties. We definecompression segment margin as the revenue derived from our compression segment.

 

(3)  Naturalgas gathered for fee (MMBtu/d) represents natural gas volumes gatheredassociated with the Kinta Area gathering assets we acquired on May 1, 2006 inwhich we do not take title to the gas.

(4)  Amountspresented in the Hiland Holdings GP, LP column include only the consolidated operationsbeginning on September 25, 2006.  These amounts include the contributionof assets and member interest from Hiland Partners GP, LLC at the completion ofour initial public offering.

(5)  Amountspresented in the Hiland Partners GP, LLC Predecessor columns include only theconsolidated operations for the period beginning February 15, 2005 to September25, 2006.

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

 

**Three Months Ended September 30, 2007Compared with Three Months Ended September 30, 2006**

 

***Revenues.***  Total revenues(midstream and compression) were $67.6 million for the three months endedSeptember 30, 2007 compared to $57.3 million for the three months endedSeptember 30, 2006, an increase of $10.3 million, or 18.1%.  This $10.3million increase was due to increased natural gas sales volumes of 14,718MMBtu/day (MMBtu per day) and increased NGL sales volumes of 1,482 Bbls/day(Bbls per day) primarily related to natural gas and NGL sales at the newWoodford Shale gathering system and increased natural gas and NGL volumes atthe existing Bakken, Badlands and Eagle Chief gathering systems. The increasein revenues is also attributable to 6.4% higher realized NGL prices but isoffset by 13.0% lower natural gas prices during the three months endedSeptember 30, 2007 compared to the same period in 2006. Revenues fromcompression assets were the same for both periods.

 

Midstream revenues were$66.4 million for the three months ended September 30, 2007 compared to $56.1million for the three months ended September 30, 2006, a net increase of $10.3million, or 18.5%. Of the $10.3 million increase, $15.5 million was primarilyattributable to revenues from natural gas and NGL sales volumes at the newWoodford Shale gathering system and increased natural gas and NGL sales volumesat the Bakken, Badlands and Eagle Chief gathering systems. Increased NGL pricesaccounted for another $1.4 million increase in revenues during the three monthsended September 30, 2007 compared to the same period in 2006. These increaseswere offset by $6.6 million in lower natural gas prices during the three monthsended September 30, 2007 compared to the same period in 2006. The WoodfordShale gathering system, which began production in late April, 2007, accountedfor 49.4% of the $10.3 million increase contributing $5.1 million to midstreamrevenues.

 

Inlet natural gas volumeswere 219,544 MCF/d for the three months ended September 30, 2007 compared to203,721 MCF/d for the three months ended September 30, 2006, an increase of15,823 MCF/d, or 7.8%.  Of the 15,823 MCF/d increase, 7,704 MCF/d wasattributable to the new Woodford gathering system and the remaining 8,119 MCF/dwas primarily attributable to increased inlet MCF/d at the Eagle Chief, Bakkenand Badlands gathering systems. Badlands increase in inlet MCF/d represented3,807 MCF/d, or 24.1% of the 15,823 MCF/d increase for the three months endedSeptember 30, 2007 compared to the three months ended September 30, 2006.Natural gas sales volumes were 84,281 MMBtu/d for the three months endedSeptember 30, 2007 compared to 69,563

 

30

----

 

MMBtu/d for the three months ended September 30, 2006, an increase of14,718 MMBtu/d, or 21.2%.  Of the 14,718 MMBtu/d increase, 6,275, or 42.6%was attributable to natural gas volumes at the new Woodford Shale gatheringsystem. The increase in natural gas sales volumes was also attributable toincreased volumes at both the Bakken and Eagle Chief gathering systems, whichcombined contributed 8,483 MMBtu/d. NGL sales volumes were 4,721 Bbls/d for thethree months ended September 30, 2007 compared to 3,239 Bbls/d for the threemonths ended September 30, 2006, an increase of 1,482 Bbls/d, or 45.8%. The new Woodford Shale gathering system contributed 577 Bbls/d and represented38.9% of the increase in NGL sales volumes and increased NGL sales volumes of743 Bbls/d at the Bakken, Badlands and Eagle Chief gathering systemsrepresented 50.1% of the increase in NGL sales volumes.

 

The average realizednatural gas sales prices were $5.20 per MMBtu for the three months endedSeptember 30, 2007 compared to $5.98 per MMBtu for the three months ended September30, 2006, a decrease of $0.78 per MMBtu, or 13.0%.  Average realized NGLsales prices were $1.16 per gallon for the three months ended September 30,2007 compared to $1.09 per gallon for the three months ended September 30,2006, an increase of $0.07 per gallon or 6.4%.  The change in averagerealized natural gas sales prices was primarily a result of lower natural gasprices due to a softening of supply and demand fundamentals causing natural gasprices to fall during the three months ended September 30, 2007 compared to thethree months ended September 30, 2006. The lower natural gas prices experiencedin the indicated period was partially offset by higher NGL index prices due toa tightening of supply and demand fundamentals for energy, which caused crudeoil prices to rise during the three months ended September 30, 2007 compared tothe three months ended September 30, 2006.

 

Net cash received from acounterparty on cash flow swap contracts for natural gas derivativetransactions that closed during each of the three months ended September 30,2007 and 2006 was $1.4 million. These receipts increased average realizednatural gas sales prices by $0.20 per MMBtu in 2007 and by $0.22 per MMBtu in2006. Cash paid to the counterparty on cash flow swap contracts for NGLderivative transactions that closed during the three months ended September 30,2007 was $0.6 million. These payments decreased average realized natural gassales prices by $0.02 per gallon in 2007. NGL derivative transactions duringthe three months ended September 30, 2006 were insignificant.

 

Fees earned from 124,121MMBtu/d of natural gas gathered, in which title is not taken to the gas,related to the Kinta Area gathering assets acquired on May 1, 2006 were $2.9million for the three months ended September 30, 2007. Similar fees earned forthe three months ended September 2006 from 129,168 MMBtu/d of natural gasgathered was $2.7 million. The increase of $0.2 million in fees earned duringthe three months ended September 30, 2007 as compared to the three months endedSeptember 2006 was attributable to treating fees earned from the four aminetreating facilities installed in early 2007 offset by a 5,047 MMBtu/d reductionin volumes gathered.

 

Our compression revenueswere $1.2 million for the each of the three months ended September 30, 2007 and2006.

 

***Midstream Purchases.***  Midstreampurchases were $45.8 million for the three months ended September 30, 2007compared to $39.6 million for the three months ended September 30, 2006, anincrease of $6.2 million, or 15.6%.  The $6.2 million increase consistedof $3.9 million related to purchased natural gas volumes from the new WoodfordShale gathering system and $2.5 million attributable to increased purchasedresidue gas volumes at the Eagle Chief gathering system. The increase involumes was offset by reduced payments to producers due primarily to lowernatural gas purchase prices, which generally are closely related tofluctuations in natural gas sales prices.

 

***Operations and Maintenance.*** Operations and maintenance expense totaled $6.2 million for the three monthsended September 30, 2007 compared with $4.6 million for the three months endedSeptember 30, 2006, an increase of $1.6 million, or 34.8%. Of this increase,$0.7 million, or 41.8% was attributable to operations and maintenance at theBadlands gathering system largely due to compressor rentals and other relatedcosts associated with the expansion project. The increase in operations andmaintenance is also attributable to the new Woodford Shale gathering systemwhich accounted for $0.3 million, or 19.7%, of the increase and operations andmaintenance at the Kinta Area gathering system, which accounted for $0.3million, or 16.1% of the increase.

 

***Depreciation, Amortization and Accretion.*** Depreciation, amortization and accretion expense totaled $7.9 million for thethree months ended September 30, 2007 compared with $6.5 million for the threemonths ended September 30, 2006, an increase of $1.4 million, or 21.8 %. Of this increase, $0.5 million, or 34.9% was attributable to our Bakkengathering system related to our fractionation facility, rail terminal andpipeline constructed in 2007 and $0.3 million, or 23.9% was attributable to thenitrogen rejection and related facilities at our Badlands gathering system,which was placed in service in late August 2007. The increase is alsoattributable to additional depreciation of $0.2 million, or 12.6%, at our KintaArea gathering system primarily related to the amine treating facilities whichbecame operational in early 2007.

 

***General and Administrative.***  Ourgeneral and administrative expense totaled $2.1 million for the three monthsended September 30, 2007 compared with $1.4 million for the three months endedSeptember 30, 2006, an increase of $0.7 million, or 47.0%.  The increaseis primarily attributable to acquisition evaluation expenses and increasedsalaries and additional staffing, as well as, the expense relating to therecalculated fair value of the Class B common units. The increase is also attributableto the costs of being a new public company, including the costs of audit andtax preparation fees.

 

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***Other Income (Expense).*** Our otherincome (expense) totaled ($3.1) million for the three months ended September30, 2007 compared with ($2.5) million for the three months ended September 30,2006, an increase in expense of $0.7 million.  The increase is attributableto interest expense from borrowings on Hiland Partners credit facility forinternal plant and pipeline expansion projects primarily at the Woodford Shale,Badlands and Bakken gathering systems.

 

***Minority Interest.  ***Minority interest in income of Hiland Partners, which represents the allocationof Hiland Partners earnings to its limited partner interests not owned byHiland Holdings, totaled $0.9 million for the three months ended September 30,2007 compared to $2.8 million for the three months ended September 30,2006. This $1.9 million decrease is attributable to the increase in ownershipof Hiland Partners. As of  September 30,2007 Hiland Holdings’ aggregate ownership interest in Hiland Partners consistedof the 2% general partner interest; 100% of the incentive distribution rights;and 1,301,471 common units and 4,080,000 subordinated units of Hiland Partners,representing a 57.8% limited partner interest in Hiland Partners as compared toSeptember 30, 2006, at which time Hiland Partners GP, LLC’s aggregate ownershipinterest in Hiland Partners consisted of the 2% general partner interest inHiland Partners, 100% of the incentive distribution rights, and 761,714 commonunits of Hiland Partners, representing a 8.2% limited partner interest in HilandPartners.

 

**Nine Months Ended September 30, 2007Compared with Nine Months Ended September 30, 2006**

 

***Revenues.***  Total revenues(midstream and compression) were $195.3 million for the nine months endedSeptember 30, 2007 compared to $163.4 million for the nine months endedSeptember 30, 2006, an increase of $31.9 million, or 19.5%.  This $31.9million increase was due to increased natural gas sales volumes of 14,202MMBtu/day related to the new Woodford Shale gathering system and theacquisition of the Kinta Area gathering assets effective May 1, 2006, increasedNGL sales volumes of 1,084 Bbls/day largely attributable to the new WoodfordShale, Bakken, Badlands and Eagle Chief gathering systems and increased averagerealized NGL sales prices partially offset by lower average realized naturalgas sales prices in 2007 as compared to the same period in 2006. Revenues fromcompression assets were the same for both periods.

 

Midstream revenues were$191.7 million for the nine months ended September 30, 2007 compared to $159.8million for the nine months ended September 30, 2006, a net increase of $31.9million, or 20.0%. Of this net increase in midstream revenues, approximately$44.6 million was attributable to revenues from natural gas sales volumes andgathering fee volumes related to the Kinta Area gathering assets acquisitioneffective May 1, 2006 and increased natural gas and NGL sales volumes at theBakken, Badlands, Eagle Chief and Woodford Shale gathering systems. The $44.6million increase attributable to increased natural gas, NGL and gathering feevolumes was reduced by $12.7 million due to lower average realized natural gassales prices. The Woodford Shale gathering system, which began production inlate April, 2007, accounted for 13.4% of the $31.9 million increasecontributing $6.4 million to midstream revenues.

 

Inlet natural gas volumeswere 210,878 MCF/d for the nine months ended September 30, 2007 compared to143,112 MCF/d for the nine months ended September 30, 2006, an increase of67,766 MCF/d, or 47.4%.  Of the 67,766 MCF/d increase, 57,323 MCF/d, or84.6% was attributable to inlet MCF/d at the Kinta Area gathering systemacquired effective May 1, 2006 and the remaining 10,443 MCF/d was primarilyattributable to increased inlet MCF/d at the Woodford Shale, Eagle Chief,Bakken and Badlands gathering systems. Natural gas sales volumes were 78,998MMBtu/d for the nine months ended September 30, 2007 compared to 64,796 MMBtu/dfor the nine months ended September 30, 2006, an increase of 14,202 MMBtu/d, or21.9%.  Of the 14,202 MMBtu/d increase, 6,999, or 49.3% was attributableto the natural gas volumes as a result of the Kinta gathering systemacquisition effective May 1, 2006. The increase in natural gas sales volumeswas also attributable to increased volumes at both the Bakken and Eagle Chiefgathering systems and the new Woodford Shale gathering system, whichcontributed 2,569 MMBtu/d to the increase in natural gas sales volumes. Our NGLsales volumes were 4,340 Bbls/d for the nine months ended September 30, 2007compared to 3,256 Bbls/d for the nine months ended September 30, 2006, anincrease of 1,084 Bbls/d, or 33.3%.  Of the 1,084 Bbls/d increase, 1,045Bbls/d, or 96.4% was attributable to increased NGL sales volumes at the Bakken,Eagle Chief, Badlands and Woodford Shale gathering systems.

 

Average realized naturalgas sales prices were $5.78 per MMBtu for the nine months ended September 30,2007 compared to $6.30 per MMBtu for the nine months ended September 30, 2006,a decrease of $0.52 per MMBtu, or 8.3%.  In addition, average realized NGLsales prices were $1.07 per gallon for the nine months ended September 30, 2007compared to $1.06 per gallon for the nine months ended September 30, 2006, anincrease of $0.01 per gallon or 0.9%.  The change in average realizednatural gas sales prices was primarily a result of lower index prices due to asoftening of supply and demand fundamentals for energy, which caused naturalgas prices to fall during the nine months ended September 30, 2007 compared tothe nine months ended September 30, 2006.

 

Net cash received from acounterparty on cash flow swap contracts that began on May 1, 2006 for naturalgas derivative transactions that closed during the nine months ended September30, 2007 and 2006 was $3.4 million and $2.4 million, respectively. Thesereceipts increased average realized natural gas sales prices by $0.16 per MMBtuin 2007 and by $0.14 per MMBtu in 2006. Cash paid to the counterparty on cashflow swap contracts that began on September 1, 2006 for NGL derivativetransactions that closed during the nine months ended September 30, 2007 was$1.1 million. These payments decreased average realized natural gas salesprices by $0.02 per gallon in 2007. Closed NGL derivative transactions duringthe nine months ended September 30, 2006 were insignificant.

 

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Fees earned from 124,486MMBtu/d of natural gas gathered, in which title is not taken to the gas,related to the Kinta Area gathering assets acquired on May 1, 2006 was $8.4million for the nine months ended September 30, 2007. Similar fees earned fromMay through September 2006 averaging 129,644 MMBtu/d of natural gas gatheredwas $4.5 million. The increase of $3.9 million in fees earned was primarily dueto nine months of operations in 2007 as compared to five months of operationsin 2006, and partially attributable to treating fees earned related to the fouramine treating facilities installed in early 2007. Gathering fees earned duringthe nine months ended September 2007 as compared to the same period in 2006were offset by the effect of a 5,158 MMBtu/d reduction in volumes gathered.

 

Our compression revenueswere $3.6 million for the each of the nine months ended September 30, 2007 and2006.

 

***Midstream Purchases.***  Midstreampurchases were $137.3 million for the nine months ended September 30, 2007compared to $118.0 million for the nine months ended September 30, 2006, anincrease of $19.3 million, or 16.4%.  The $19.3 million increase primarilyconsists of $9.7 million, or 50.1%, attributable to purchased natural gas fromthe Kinta Area gathering assets. The new Woodford Shale gathering systemaccounted for $5.1 million, or 26.2%, of the increase in midstream purchases.The remaining increase in midstream purchases was attributable to increasedpurchased natural gas volumes at the Bakken and Eagle Chief gathering systems.The increase in volumes was offset by reduced payments to producers dueprimarily to lower natural gas purchase prices, which generally are closelyrelated to fluctuations in natural gas sales prices.

 

***Operations and Maintenance.***  Ouroperations and maintenance expense totaled $16.1 million for the nine monthsended September 30, 2007 compared with $11.1 million for the nine months endedSeptember 30, 2006, an increase of $5.0 million, or 44.6%. Of this increase,$2.9 million, or 53.1% was attributable to operations and maintenance at theKinta Area gathering system. Operations and maintenance expense increased by$1.3 million at the Badlands gathering facility largely due to compressorrentals and other related costs associated with our expansion project.

 

***Depreciation, Amortization and Accretion.*** Our depreciation, amortization and accretion expense totaled $22.2 million forthe nine months ended September 30, 2007 compared with $16.3 million for thenine months ended September 30, 2006, an increase of $5.9 million, or 36.7%.  Of this increase, $2.9 million, or 53.1% was attributable todepreciation and amortization on the Kinta Area gathering system. The increaseis also attributable to additional depreciation of $1.2 million, or 21.2% atthe Bakken gathering system and $0.5 million, or 9.6% at the Badlands gatheringsystem.

 

***General and Administrative.***  Ourgeneral and administrative expense totaled $6.4 million for the nine monthsended September 30, 2007 compared with $3.7 million for the nine months endedSeptember 30, 2006, an increase of $2.7 million, or 72.7%.  The increaseis primarily attributable to acquisition evaluation expenses and increasedsalaries and additional staffing, including costs to recruit the new CEO, aswell as, the expense relating to the recalculated fair value of the Class Bcommon units. The increase is also attributable to the costs of being a new publiccompany, including the costs of audit and tax preparation fees

 

***Other Income (Expense).*** Our otherincome (expense) totaled ($7.6) million for the nine months ended September 30,2007 compared with ($4.8) million for the nine months ended September 30, 2006,an increase in expense of $2.7 million.  The increase is primarilyattributable to additional interest expense from borrowings on Hiland Partnerscredit facility for the acquisition of the Kinta Area gathering assetseffective May 1, 2006 and to interest expense for internal plant and pipelineexpansion projects primarily at the Woodford Shale, Badlands and Bakkengathering systems.

 

***Minority Interest.  ***Minority interest in income of Hiland Partners, which represents the allocationof Hiland Partners earnings to its limited partner interests not owned byHiland Holdings, totaled $2.1 million for the nine months ended September 30,2007 compared to $9.0 million for the nine months ended September 30, 2006.This $6.9 million decrease is attributable to the increase in ownership ofHiland Partners. As of September 30, 2007 Hiland Holdings’ aggregate ownershipinterest in Hiland Partners consisted of the 2% general partner interest; 100%of the incentive distribution rights; and 1,301,471 common units and 4,080,000subordinated units of Hiland Partners, representing a 57.8% limited partnerinterest in Hiland Partners as compared to September 30, 2006, at which timeHiland Partners GP, LLC’s aggregate ownership interest in Hiland Partnersconsisted of the 2% general partner interest in Hiland Partners, 100% of theincentive distribution rights, and 761,714 common units of Hiland Partners,representing a 8.2% limited partner interest in Hiland Partners

 

**LIQUIDITYAND 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 are HilandPartners’ primary sources of liquidity. We believe that funds from thesesources should be sufficient to meet both Hiland Partners’ short-term workingcapital requirements and its long-term capital expenditure requirements. HilandPartners’ ability to pay distributions to unitholders, to fund planned capitalexpenditures and to make acquisitions depends upon Hiland Partners’ futureoperating performance, and more broadly, on the availability of equity and debtfinancing, which will be affected by prevailing economic conditions in HilandPartners’ industry and financial, business and other factors, many of which arebeyond Hiland Partners’ control.

 

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***Cash Flows from Operating Activities***

 

 Cash flows fromoperating activities decreased by $2.2 million to $28.2 million for the ninemonths ended September 30, 2007 from $30.4 million for the nine months endedSeptember 30, 2006. During the nine months ended September 30, 2007 we receivedcash flows from customers of approximately $196.1 million, had cash payments toour suppliers and employees of approximately $160.4 million and payment ofinterest expense of $7.5 million, net of amounts capitalized, resulting in cashreceived from our operating activities of $28.2 million. During the same ninemonth period in 2006, we received cash flows from customers of approximately$168.1 million, had cash payments to our suppliers and employees ofapproximately $134.4 million and payment of interest expense of $4.6 million,net of amounts capitalized, resulting in cash received from our operatingactivities of $30.4 million. Changes in cash receipts and payments areprimarily due to the timing of collections at the end of the reporting periods.We collect and pay large receivables and payables at the end of each calendarmonth. The timing of these payments and receipts may vary by a day or twobetween month-end periods and cause fluctuations in cash received or paid.Natural gas volumes from the Kinta Area gathering assets acquired effective May1, 2006, natural gas and NGL volumes from the new Woodford Shale gatheringsystem and increased natural gas and NGL volumes from the Bakken, Badlands andEagle Chief gathering systems, offset by lower natural gas sales pricescontributed to slight increases in accounts receivable and accrued midstreamrevenues and increases in accounts payable and accrued midstream purchasesduring the nine months ended September 30, 2007. Working capital items,exclusive of cash, used $0.6 million in cash flows from operating activitiesand contributed $4.1 million to cash flows from operating activities during thenine months ended September 30, 2007 and 2006, respectively. Net income for thenine months ended September 30, 2007 was $3.6 million, an increase of $3.0million from a net income of $0.5 million for the nine months ended September30, 2006.  Depreciation, amortization and accretion increased by $5.9million to $22.1 million for the nine months ended September 30, 2007 from$16.2 million for the nine months indeed September 30, 2006.

 

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

 

Cash flows used forinvesting activities representing investments in property and equipment,excluding $96.4 million used for the Kinta Area acquisition on May 1, 2006,increased by $14.0 million to $61.9 million for the nine months ended September30, 2007 from $47.9 million for the nine months ended September 30, 2006. This$14.0 million increase is largely attributable to cash invested at the newWoodford Shale gathering system, the Badlands expansion project and continuedgrowth at the Bakken gathering system.

 

***Cash Flows from Financing Activities***

 

Cash flows from financingactivities decreased by $86.5 million to $32.1 million for the nine monthsended September 30, 2007 from $118.6 million for the nine months endedSeptember 30, 2006. During the nine months ended September 30, 2007,Hiland Partners borrowed $54.0 million under its credit facility to fund itsinternal expansion projects and received $1.0 million from issuing Hiland Partnerscommon units as a result of the exercise of 42,362 vested unit options.During the nine months ended September 30, 2007, we made a distribution of$13.7 million to our unitholders and Hiland Partners distributed$8.5 million to its minority interest unitholders, Hiland Partnersincurred offering costs of $0.2 million associated with its S-3/A registrationstatement filed with the SEC on January 23, 2007 and paid debt issuance costsof $0.5 million associated with its amended credit facility and paid down its capitallease obligation by $0.2 million. During the nine months ended September 30,2006, we completed our initial public offering of 8,050,000 common units onSeptember 25, 2006, receiving net proceeds of $139.6 million. Theproceeds from the public offering were used to repay approximately $1.8 millionin offering costs, $35.0 million of outstanding debt of the HLND, GP, plusaccrued interest of approximately $1.0 million, and distributed to theContributing Parties as follows: (1) $57.5 million to Mr. Hamm,(2) $24.1 million to the Harold Hamm DST Trust,(3) $16.1 million to the Harold Hamm HJ Trust,(4) $2.9 million to Randy Moeder and (5) $1.2 million toKen Maples. During the nine months ended September 30, 2006, Hiland Partnersborrowed $100.3 million under its credit facility to partially fund the KintaArea gathering assets acquisition on May 1, 2006 and to fund its internalexpansion projects at Badlands and Bakken. On May 1, 2006, Hiland PartnersGP, LLC borrowed $35.0 million to purchase 761,714 common units and 15,545general partner units of Hiland Partners, which was used by Hiland Partners tocomplete the Kinta Area gathering assets acquisition on the same day. Duringthe nine months ended September 30, 2006, we incurred $0.4 million of debt issuancecosts and Hiland Partners incurred $0.9 million. Hiland Partners GP, LLC’smembers contributed $0.5 million as a capital contribution. Hiland Partnersreceived $1.0 million from issuing Hiland Partners common units as a result ofthe exercise of 47,533 vested unit options. Hiland Partners distributed$16.5 million to minority interest unitholders, and Hiland Partners GP,LLC distributed $1.8 million to its members.

 

***Capital Requirements***

 

The midstream energybusiness is capital intensive, requiring significant investment to maintain andupgrade existing operations. Our capital requirements have consisted primarilyof, and we anticipate will continue to be:

 

•   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

 

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upgrade gatheringsystems, processing plants, treating facilities and fractionation facilitiesand to construct or acquire similar systems or facilities.

 

Hiland Partners believesthat cash generated from the operations of its business will be sufficient tomeet 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 Partnersactively considers a variety of assets for potential acquisitions. Weanticipate that expansion capital expenditures will be funded through long-termborrowings or other debt financings and/or equity offerings.

 

***Internal ExpansionProjects***

 

During the second quarter2007, Hiland Partners connected its first well related to the agreement withContinental Resources, Inc. to construct and operate gathering pipelines andrelated facilities associated with the development of acreage owned byContinental Resources, Inc. in the Woodford Shale Play in the Arkoma Basin ofsoutheastern Oklahoma. The gathering system is being designed to providelow-pressure and highly reliable gathering, compression, dehydration, andprocessing services. When completed, the gathering infrastructure is expectedto include more than 15,500 horsepower of compression to provide takeawaycapacity in excess of 40,000 Mcf/d. As of September 30, 2007, Hiland Partnershas invested $15.1 million in the expansion project.

 

During the third quarter2007, Hiland Partners completed the expansion of its Badlands gathering system,the associated field gathering infrastructure and processing plant, whichincluded the completion of a 40,000 Mcf/d nitrogen rejection plant. As aresult, gathering pipelines, processing plant, treating facility and fractionationfacility throughput capacities have increased significantly.

 

During the third quarter2007, Hiland Partners completed the expansion of the existing NGL fractionationfacility at the Bakken processing plant enabling it to fractionate increased NGLvolumes from both the Bakken processing plant and the Badlands processingplant. Additionally, during the second quarter 2007 construction was completedon a rail terminal which allows transportation of NGL volumes not only bytruck, but also by rail, thereby penetrating additional sales markets. Thepipeline to the rail terminal was completed early in the third quarter 2007.

 

***Financial Derivatives and Commodity Hedges.***

 

Hiland Partners hasentered into certain financial derivative instruments that are classified ascash flow hedges in accordance with SFAS No. 133, as amended, and relateto forecasted sales in 2007, 2008 and 2009. Hiland Partners entered into theseinstruments to hedge the forecasted natural gas and natural gas liquid sales orpurchases against the variability in expected future cash flows attributable tochanges in market prices. The swap instruments are contractual agreementsbetween counterparties to exchange obligations of money as the underlyingnatural gas or natural gas liquids are sold or purchased. Under these swapagreements, Hiland Partners either receives or pays a monthly net settlementthat is determined by the difference between a fixed price and a floating pricebased on certain indices for the relevant contract period for the agreed uponvolumes. One financial swap instrument currently does not qualify for hedgeaccounting.

 

The following tableprovides information about these financial derivative instruments entered intoas of September 30, 2007 for the periods indicated:

 

| **Description and Production Period**              | ** ** | **Volume**  | ** ** | **Average  Fixed Price** | ** ** | **Fair Value  Asset  (Liability)** | ** ** |
|-------------------------------------------------------------------|------------|-------------|------------|-------------------------------|------------|-----------------------------------------|------------|
|                                                              |       |        |       |                          |       |                                    |       |
| **Natural  Gas—Sold Fixed for Floating Price Swaps**         | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**               | ** ** | ** **                              | ** ** |
| October 2007 –  September 2008                          |       | 1,890,000   |       | $                             | 7.88       |                                    | $          | 4,144 |   |
| October 2008 –  December 2008                                |       | 495,000     |       | 7.84                          |       | 485                                     |       |
| January 2009  - December 2009                           |       | 1,068,000   |       | $                             | 7.06       |                                    | 186        |   |
|                                                              |       |        |       |                          |       | $                                       | 4,815      |   |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| **Natural  Gas - Sold Open for Floating Price Swaps**             | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**               | ** ** | ** **                              | ** ** |
| January 2009 -  December 2009                                     |       | 1,068,000   |       | $                             | 7.35       |                                    | $          | 485 |   |
|                                                              |       |        |       |                          |       |                                    |       |
| **Natural  Gas—Buy Fixed for Floating Price Swaps**          | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**               | ** ** | ** **                              | ** ** |
| October 2007 –  September 2008                          |       | 859,986     |       | $                             | 7.48       |                                    | $          | (963 | ) |
| October 2008 –  December 2008                                |       | 180,288     |       | 6.93                          |       | 21                                      |       |
|                                                              |       |        |       |                          |       | (942                                    | )          |
|                                                              |       |        |       |                          |       |                                    |       |
| **Natural  Gas Liquids–Sold Fixed for Floating Price Swaps** | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(Bbls)**  | ** ** | **(per Gallon)**              | ** ** | ** **                              | ** ** |
| October 2007 –  September 2008                          |       | 441,768     |       | $                             | 1.29       |                                    | (2,697     | ) |
| October 2008 –  December 2008                                |       | 110,442     |       | $                             | 1.31       |                                    | (347       | ) |
|                                                              |       |        |       |                          |       | $                                       | (3,044     | ) |

 

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On July 16, 2007, HilandPartners entered into NGL cash flow swaps adding to Hiland Partners hedges forforecasted NGL sales through calendar year 2008. Under the swap agreementsHiland Partners pays its counterparty floating index prices and receives fixedprices of $1.35 per gallon on 24,093 Bbls/month during August 2007 throughDecember 2007 and $1.31 per gallon on 33,634 Bbls/month during calendar year2008.

 

On July 16, 2007, HilandPartners also entered into natural gas cash flow swaps adding to HilandPartners hedges for forecasted natural gas purchases through calendar year2008.  Under the swap agreement Hiland Partners receives floating indexprices and pays its counterparty fixed prices of $5.56 per MMBtu on 33,235MMBtu/month during August 2007 through December 2007 and $6.97 per MMBtu on53,381 MMBtu/month during calendar year 2008.

 

In addition to thederivative instruments noted above, Hiland Partners has executed variousnatural gas fixed price physical forward sales contracts on approximately115,000 MMBtu per month for the remainder of 2007 and 100,000 MMBtu per monthfor 2008 with fixed prices ranging from $4.49 to $9.13 per MMBtu in 2007 and$8.43 per MMBtu in 2008. These contracts have been designated as normal salesunder SFAS No. 133 and are therefore not marked to market as derivatives.A summary of our fixed price physical forward sales contracts is presented inthe table below:

 

| ** **                                   | ** ** | ** **  | ** ** | **Average**          | ** ** |
|----------------------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                                   | ** ** | ** **  | ** ** | **Fixed Price** | ** ** |
| **Production Period**                   | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** |
| ** **                                   | ** ** | ** **  | ** ** | ** **           | ** ** |
| October 2007 –  September 2008     |       | 1,245,000   |       | $                    | 8.01       |   |
| October 2008  – December 2008 |       | 300,000     |       | $                    | 8.43       |   |

 

***Off-Balance Sheet Arrangements.***

 

We had no significantoff-balance sheet arrangements as of September 30, 2007.

 

***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. Thefacility will permit us, if certain conditions are met, to increase borrowingcapacity by up to an additional $25.0 million. The facility will be secured byall of our ownership interests in Hiland Partners and its general partner,other than the 2% general partner interest and the incentive distributionrights.

 

The facility will matureon September 25, 2009, at which time all outstanding amounts thereunder becomedue and payable.

 

Loans under the facilitywill bear interest, at our option, at either (i) an alternate base rateplus an applicable margin ranging from 100 to 150 basis points per annum or(ii) LIBOR plus an applicable margin ranging from 200 to 250 basis pointsper annum in each case based on our ratio of consolidated funded debt toEBITDA. The alternate base rate is equal to the greatest of (a) the primerate in effect on such day, (b) the base CD rate in effect on such dayplus 1.50% and (c) the federal funds effective rate in effect on such dayplus 1/2 of 1%. A letter of credit fee will be payable for the aggregate amountof letters of credit issued under the facility at a percentage per annum equalto 2.0%. A commitment fee ranging from 25 to 50 basis points per annum based onour ratio of consolidated funded debt to EBITDA will be payable on the averagedaily unused portion of the facility for the quarter most recently ended. AtSeptember 30, 2007, the interest rate on outstanding borrowings from our creditfacility was 7.80%.

 

The facility containsseveral covenants that, among other things, require the maintenance of two financialperformance ratios, restrict the payment of distributions to unitholders, andrequire financial reports to be submitted periodically to the financialinstitutions.

 

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 facility is limited to the lesser of: (i) 50% of the sum of thevalue of the Hiland Partners common and subordinated units and certain otherassets held by us and certain of our subsidiaries at the end of each fiscalquarter and (ii) the maximum available amount of the facility (currently$25.0 million). For purposes of this calculation, the value of (i) theHiland Partners common units on any date shall be the closing price for suchunits as reflected on the Nasdaq National Market on any date, and (ii) theHiland Partners subordinated units on any date shall be deemed to equal 85% ofthe value of the Hiland Partners common

 

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units on such date.

 

The facility prohibits usfrom making distributions to unitholders if any default or event of default, asdefined in the credit facility, has occurred and is continuing or would resultfrom the distribution. In addition, the facility contains various covenantsthat limit, among other things, subject to certain exceptions and negotiated “baskets,”our ability to incur indebtedness, grant liens, enter into agreementsrestricting our ability to grant liens on our assets or amend the facility,make certain loans, acquisitions and investments or enter into a merger,consolidation or sale of assets.

 

The facility limitsdistributions to our unitholders to our available cash, as defined in ourpartnership agreement. Restricted payments under the facility are subject to anannual “clean-down” period of 15 consecutive days in which the amountoutstanding that relates to funding the restricted payments under the facilitymust be reduced to zero.

 

As of September 30, 2007,we had $0.4 million outstanding under this credit facility and were incompliance with our financial covenants.

 

***Hiland Partners GP, LLC***

 

On May 1, 2006,Hiland Partners GP, LLC entered into an unsecured credit agreement under whichit borrowed $35.0 million to purchase 761,714 common units and 15,545 generalpartner units from Hiland Partners. The loan was guaranteed by all HilandPartners GP, LLC’s members and matured and was paid in full upon the completionof our initial public offering on September 25, 2006. Hiland Partners GP,LLC’s board of directors, as well as the conflicts committee of its board ofdirectors, consisting of independent directors, approved the transaction.

 

***Hiland Partners***

 

On July 13, 2007, HilandPartners entered into a third amendment to its credit facility dated as ofFebruary 15, 2005. Pursuant to the third amendment, Hiland Partners may, amongother things, increase its borrowing base from $200 million to $250 million anddecrease the accordion feature in the facility from $150 million to $100million.

 

The third amendmentincreased Hiland Partners’ borrowing capacity under its senior securedrevolving credit facility to $250 million such that the facility now consists ofa $241 million senior secured revolving credit facility to be used for fundingacquisitions and other capital expenditures, issuance of letters of credit andgeneral corporate purposes (the “Acquisition Facility”) and a $9.0 millionsenior secured revolving credit facility to be used for working capital and tofund distribution (the “Working Capital Facility”).

 

In addition, the thirdamendment provides for an accordion feature, which permits Hiland Partners, ifcertain conditions are met, to increase the size of the Acquisition Facility byup to $100 million and allows for the issuance of letters of credit of up to$15 million in the aggregate.  The senior secured revolving creditfacility also requires Hiland Partners to meet certain financial tests, includinga maximum consolidated funded debt to EBITDA ratio of 4.0:1.0 as of the lastday of any fiscal quarter; provided that in the event that the Partnershipmakes certain 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.

 

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) an alternate base rate plus an applicable margin ranging from 50 to125 basis points per annum or (ii) LIBOR plus an applicable margin rangingfrom 150 to 225 basis points per annum based on our ratio of consolidated fundeddebt to EBITDA. The Alternate Base Rate is a rate per annum equal to thegreatest of (a) the Prime Rate in effect on such day, (b) the base CDrate in effect on such day plus 1.50% and (c) the Federal Funds effectiverate in effect on such day plus 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 1.0%. An unused commitment fee ranging from25 to 50 basis points per annum based on our ratio of consolidated funded debtto EBITDA will be payable on the unused portion of the credit facility. Duringany step-up period, the applicable margin with respect to loans under thecredit facility will be increased by 35 basis points per annum and the unusedcommitment fee will be increased by 12.5 basis points per annum. At September30, 2007, the interest rate on outstanding borrowings from Hiland Partners’credit facility was 7.75%.

 

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,” our ability to incurindebtedness, grant liens, make certain loans, acquisitions and investments,make any material changes to the nature of its business, amend its materialagreements, including its Omnibus Agreement, which contains non-compete andindemnity provisions with affiliates, or enter into a merger, consolidation orsale of assets.

 

The credit facility alsocontains covenants requiring Hiland Partners to maintain a maximum consolidatedfunded debt to EBITDA

 

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ratio of 4.0:1.0, provided that in the event Hiland Partners makescertain permitted acquisitions or capital expenditures, the credit facilityallows this ratio to increase to 4.75:1.0 for the following three fiscalquarters (a “step-up period”) and a minimum interest coverage ratio of 3.0:1.0.

 

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

 

Upon 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 September 30, 2007,Hiland Partners had $201.1 million outstanding under this credit facilityand was in compliance with its financial covenants.

 

***Impact of Inflation***

 

Inflation in the UnitedStates has been relatively low in recent years and did not have a materialimpact on our results of operations for the periods presented.

 

**RecentAccounting Pronouncements**

 

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities”. SFAS No. 159 expands opportunities to use fairvalue measurement in financial reporting and permits entities to choose tomeasure many financial instruments and certain other items at fair value. SFASNo. 159 is effective for fiscal years beginning after November 15,2007. We believe we will not choose to measure any eligible financial assetsand liabilities at fair value.

 

In September 2006,the FASB issued SFAS No. 157 “Fair Value Measurements.”  SFASNo. 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 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 disclosure aboutfair value measurements based on their level in the hierarchy. SFASNo. 157 applies to derivatives and other financial instruments, whichStatement 133,*Accounting for DerivativeInstruments and Hedging Activities* , as amended, requires bemeasured at fair value at initial recognition and for all subsequent periods.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears. We will apply the provisions of SFAS No. 157 prospectively in ourfirst interim period in the fiscal year beginning on January 1, 2008, andwe do not expect a change in our methodologies of fair value measurements.

 

**SignificantAccounting Policies and Estimates**

 

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

 

***Derivatives****.  * We utilize derivative financial instruments toreduce commodity price risks. We do not hold or issue derivative financialinstruments for trading purposes. Statement of Financial Accounting Standards(or SFAS) No. 133, “Accounting for Derivative Instruments and HedgingActivities”, which was amended in June 2000 by SFAS No. 138 and inMay 2003 by SFAS No. 149, establishes accounting and reportingstandards for derivative instruments and hedging activities. It requires thatan entity recognize all derivatives as either assets or liabilities in thestatement of financial condition and measure those instruments at fair value.Derivatives that are not designated as hedges are adjusted to fair valuethrough income. If the derivative is designated as a hedge, depending upon thenature of the hedge, changes in the fair value of the derivatives are eitheroffset against the fair value of assets, liabilities or firm commitmentsthrough income, or recognized in other comprehensive income until the hedgeditem is recognized in income. The ineffective portion of a derivative’s changein fair value is immediately recognized into income. If a derivative no longerqualifies for hedge accounting the amounts in accumulated other comprehensiveincome will be immediately charged to operations.

 

***Depreciation and Amortization.****  * Depreciation of all equipmentis determined under the straight-line method using various rates based onuseful lives, 10 to 22 years for pipeline and processing plants, and 3 to10 years for corporate and other assets. The cost of assets and relatedaccumulated depreciation is removed from the accounts when such assets aredisposed of, and any related gains or losses are reflected in current earnings.Maintenance, repairs and minor replacements are expensed as incurred. Costs ofreplacements constituting improvement are capitalized. Intangible assetsconsist of the acquired value of existing contracts to sell natural gas and

 

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other NGLs, compression contracts and identifiable customerrelationships, which do not have significant residual value. The contracts arebeing amortized over their estimated lives of ten years.

 

***Asset Retirement Obligations****.  * SFAS No. 143 “Accountingfor Asset Retirement Obligations” requires entities to record the fair value ofa liability 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 this standard relates to our estimated costs for dismantling and siterestoration of certain of our plants and pipelines. Estimating future asstretirement obligations requires us to make estimates and judgments regardingtiming, existence of a liability, as well as what constitutes adequaterestoration. We use the present value of estimated cash flows related to ourasset retirement obligation to determine the fair value, generally as estimatedby third party consultants. The present value calculation requires us to makenumerous assumptions and judgments, including the ultimate costs of dismantlingand site restoration, inflation factors, credit adjusted discount rates, timingof settlement 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, acorresponding adjustment will be required to the related asset. We believe theestimates and judgments reflected in our financial statements are reasonablebut are necessarily subject to the uncertainties we have just described.Accordingly, any significant variance in any of the above assumptions orfactors could materially affect our cash flows.

 

***Impairment of Long-Lived Assets****.  * In accordance with Statementof Financial Accounting Standards (SFAS) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” we evaluate our long-livedassets, including intangible assets, of identifiable business activities forimpairment when events or changes in circumstances indicate, in management’sjudgment, that the carrying value of such assets may not be recoverable. Thedetermination of whether impairment has occurred is based on management’sestimate of undiscounted future cash flows attributable to the assets ascompared to the carrying value of the assets. If impairment has occurred, theamount of the impairment recognized is determined by estimating the fair valuefor the assets and recording a provision for loss if the carrying value isgreater than fair value. For assets identified to be disposed of in the future,the carrying value of these assets is compared to the estimated fair value lessthe cost to sell to determine if impairment is required. Until the assets aredisposed of, an estimate of the fair value is re-determined when related eventsor circumstances change.

 

When determining whetherimpairment of one of our long-lived assets has occurred, we must estimate theundiscounted cash flows attributable to the asset or asset group. Our estimateof cash flows is based on assumptions regarding the volume of reservesproviding asset cash flow and future NGL product and natural gas prices. Theamount of reserves and drilling activity are dependent in part on natural gasprices. Projections of reserves and future commodity prices are inherentlysubjective and contingent upon a number of variable factors, including, but notlimited to:

 

•     changes ingeneral economic conditions in regions in which the Partnership’s products arelocated;

 

•     the availabilityand prices of NGL products and competing commodities;

 

•     theavailability and prices of raw natural gas supply;

 

•     our ability tonegotiate favorable marketing agreements;

 

•     the risks thatthird party oil and gas exploration and production activities will not occur orbe successful;

 

•     our dependenceon certain significant customers and producers of natural gas; and

 

•     competitionfrom other midstream service providers and processors, including major energycompanies.

 

Any significant variancein any of the above assumptions or factors could materially affect our cashflows, which could require us to record an impairment of an asset.

 

***Share Based Compensation.****  * In October 1995, theFASB issued SFAS No. 123, “Share-Based Payment,” which was revised inDecember 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 adopted SFAS 123R September 25, 2006 andHiland Partners adopted SFAS 123R January 1, 2006. We have applied SFAS123R using the permitted modified prospective method beginning as of the samedate. Hiland Partners had unearned deferred compensation of $289 as ofJanuary 1, 2006 which has been eliminated against Hiland Partners commonunit equity. Prior to January 1, 2006, Hiland Partners recorded anyunamortized compensation related to restricted unit awards as unearnedcompensation in equity. We expect no change to cash flow presentation from theadoption of SFAS 123R since no tax benefits were recognized by Hiland Partnersas a pass through entity.

 

We estimate the fairvalue of each option granted on the date of grant using the American Binomialoption-pricing model. In estimating the fair value of each option, we use ourpeer group volatility averages as determined on the option grant dates. Wecalculate 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 timeof grant. Our compensation expense for

 

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these awards is recognized on the graded vesting attributionmethod. Units to be issued under our unit incentive plan may be from newlyissued units. Prior to Hiland Partners adoption of SFAS 123R on January 1,2006, they applied Accounting Principles Board Opinion No. 25 and relatedinterpretations in accounting for the unit-based compensation awards.

 

**Item 3.  Quantitative and Qualitative Disclosures aboutMarket Risk**

 

Market risk is the riskof loss arising from adverse changes in market rates and prices. The principalmarket risk to which we are exposed is commodity price risk for natural gas andNGLs. We also incur, to a lesser extent, risks related to interest ratefluctuations.

 

We do not engage incommodity energy trading activities.

 

***Commodity Price Risks.  *** Ourprofitability is affected by volatility in prevailing NGL and natural gasprices. Historically, changes in the prices of most NGL products have generallycorrelated with changes in the price of crude oil. NGL and natural gas pricesare volatile and are impacted by changes in the supply and demand for NGLs andnatural gas, as well as market uncertainty. Our cash flow is affected by thevolatility of natural gas and NGL product prices, which could adversely affectour ability to make distributions to unitholders. To illustrate the impact ofchanges in prices for natural gas and NGLs on our operating results, we haveprovided below a matrix that reflects, for the nine months ended September 30,2007, the impact on our gross margin of a $0.01 per gallon change (increase ordecrease) in NGL prices coupled with a $0.10 per MMBtu change (increase ordecrease) in the price of natural gas. The magnitude of the impact on totalsegment margin of changes in natural gas and NGL prices presented may not berepresentative of the magnitude of the impact on total segment margin fordifferent commodity prices or contract portfolios. Natural gas prices can alsoaffect our profitability indirectly by influencing the level of drillingactivity and related opportunities for our services.

 

| ** **          | ** ** | **Natural Gas Price Change ($ /MMBtu)** | ** ** |
|---------------------|------------|------------------------------------------------------------------|------------|
|                |       |                                                             |       | $ | 0.10 |   | $ | (0.10 | ) |
| **NGL  Price**      |       | $                                                                | 0.01       |   | $ | 461,000 |   | $ | 109,000 |   |
| **Change  ($/gal)** |       | $                                                                | (0.01      | ) | $ | (111,000 | ) | $ | (464,000 | ) |

 

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 liquidprices in 2007, 2008 and 2009. 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:

 
| **Description and Production Period**              | ** ** | **Volume**  | ** ** | **Average  Fixed Price** | ** ** | **Fair Value  Asset  (Liability)** | ** ** |
|-------------------------------------------------------------------|------------|-------------|------------|-------------------------------|------------|-----------------------------------------|------------|
|                                                              |       |        |       |                          |       |                                    |       |
| **Natural  Gas—Sold Fixed for Floating Price Swaps**         | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**               | ** ** | ** **                              | ** ** |
| October 2007 –  September 2008                          |       | 1,890,000   |       | $                             | 7.88       |                                    | $          | 4,144 |   |
| October 2008 –  December 2008                                |       | 495,000     |       | 7.84                          |       | 485                                     |       |
| January 2009  - December 2009                           |       | 1,068,000   |       | $                             | 7.06       |                                    | 186        |   |
|                                                              |       |        |       |                          |       | $                                       | 4,815      |   |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| **Natural  Gas - Sold Open for Floating Price Swaps**             | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**               | ** ** | ** **                              | ** ** |
| January 2009 -  December 2009                                     |       | 1,068,000   |       | $                             | 7.35       |                                    | $          | 485 |   |
|                                                              |       |        |       |                          |       |                                    |       |
| **Natural  Gas—Buy Fixed for Floating Price Swaps**          | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**               | ** ** | ** **                              | ** ** |
| October 2007 –  September 2008                          |       | 859,986     |       | $                             | 7.48       |                                    | $          | (963 | ) |
| October 2008 –  December 2008                                |       | 180,288     |       | 6.93                          |       | 21                                      |       |
|                                                              |       |        |       |                          |       | (942                                    | )          |
|                                                              |       |        |       |                          |       |                                    |       |
| **Natural  Gas Liquids—Sold Fixed for Floating Price Swaps** | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | ** **  | ** ** | ** **                    | ** ** | ** **                              | ** ** |
| ** **                                                        | ** ** | **(Bbls)**  | ** ** | **(per Gallon)**              | ** ** | ** **                              | ** ** |
| October 2007 –  September 2008                          |       | 441,768     |       | $                             | 1.29       |                                    | (2,697     | ) |
| October 2008 –  December 2008                                |       | 110,442     |       | $                             | 1.31       |                                    | (347       | ) |
|                                                              |       |        |       |                          |       | $                                       | (3,044     | ) |

 

On July 16, 2007, HilandPartners entered into NGL cash flow swaps adding to Hiland Partners’ hedges forforecasted NGL sales through calendar year 2008. Under the swap agreementsHiland Partners pays its counterparty floating index prices and receives fixed

 

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prices of $1.35 per gallon on 24,093 Bbls/month during August 2007through December 2007 and $1.31 per gallon on 33,634 Bbls/month during calendaryear 2008.

 

On July 16, 2007, HilandPartners also entered into natural gas cash flow swaps adding to HilandPartners’ hedges for forecasted natural gas purchases through calendar year2008.  Under the swap agreement Hiland Partners receives floating indexprices and pays its counterparty fixed prices of $5.56 per MMBtu on 33,235MMBtu/month during August 2007 through December 2007 and $6.97 per MMBtu on53,381 MMBtu/month during calendar year 2008.

 

In addition to thederivative instruments noted above, Hiland Partners has executed variousnatural gas fixed price physical forward sales contracts on approximately115,000 MMBtu per month for the remainder of 2007 and 100,000 MMBtu per monthfor 2008 with fixed prices ranging from $4.49 to $9.13 per MMBtu in 2007 and$8.43 per MMBtu in 2008. These contracts have been designated as normal salesunder SFAS No. 133 and are therefore not marked to market as derivatives.A summary of our fixed price physical forward sales contracts is

 

| ** **                              | ** ** | ** **  | ** ** | **Average**          | ** ** |
|-----------------------------------------|------------|-------------|------------|----------------------|------------|
| ** **                              | ** ** | ** **  | ** ** | **Fixed Price** | ** ** |
| **Production Period**              | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** |
|                                    |       |        |       |                 |       |
| October 2007 -  September 2008     |       | 1,245,000   |       | $                    | 8.01       |   |
| October 2008  - December 2008 |       | 300,000     |       | $                    | 8.43       |   |

 

***InterestRate Risk***.   We are exposed to changes ininterest rates as a result of our credit facilities, which have floating interestrates. As of September 30, 2007, we had approximately $0.4 million ofindebtedness outstanding under our credit facility which was used to financethe costs related to the closing of our $25.0 million secured revolvingcredit facility. As of September 30, 2007, Hiland Partners had approximately$201.1 million of indebtedness outstanding under its credit facility. Theimpact of a 100 basis point increase or decrease in interest rates on theamount of Hiland Partners’ debt would result in an increase or decrease ininterest expense and a corresponding decrease or increase in net income ofapproximately $2.0 million annually.

 

***CreditRisk.***   Counterparties pursuant to the terms oftheir contractual obligations expose us to potential losses as a result ofnonperformance. Hiland Partners’ four largest customers for the nine monthsended September 30, 2007 accounted for approximately 19%, 15%, 11% and 9%,respectively, of revenues. Consequently, changes within one or more of thesecompanies’ operations have the potential to impact, both positively andnegatively, our credit exposure. Our counterparty for all of our derivativeinstruments as of September 30, 2007 is BP Energy Company.

 

**Item 4.  Controls and Procedures**

 

**Evaluationof Disclosure Controls and Procedures**

 

(a) Evaluation ofdisclosure controls and procedures.

 

Our management, under thesupervision of and with the participation of our principal executive officerand principal financial officer, has evaluated the effectiveness of ourdisclosure controls and procedures, as such term is defined in Rules 13a-15(e)and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), as of the end of the period covered by this report. Our disclosurecontrols and procedures are designed to provide reasonable assurance that theinformation required to be disclosed by us in our reports filed or submittedunder the Exchange Act is accumulated and communicated to management, includingour principal executive officer and principal financial officer, as appropriateto allow timely decisions regarding required disclosure and is recorded,processed, summarized and reported within the time periods specified in therules and forms of the Securities and Exchange Commission. Based on suchevaluation, our principal executive officer and principal financial officerhave concluded that our disclosure controls and procedures were effective as ofSeptember 30, 2007 at the reasonable assurance level. Our management does notexpect that our disclosure controls and procedures or our internal control overfinancial reporting will prevent all errors and all fraud. Further, the designof disclosure controls and internal control over financial reporting mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within a company have been detected.

 

(b) Changes in internalcontrol over financial reporting.

 

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

 

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**PART II. OTHER INFORMATION**

 

**Item 1.  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 significantfinancial impact on our consolidated financial condition, results of operationsor cash flows.

 

**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, 2006 and in Part II, Item 1A. “Risk Factors” inour Quarterly Report on Form 10-Q for the quarter ended March 31, 2007, whichcould materially affect our business, financial condition or future results.The risks described in our Annual Report on Form 10-K and in our QuarterlyReport on Form 10-Q are not the only risks facing our Company. Additional risksand uncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition and/or operating results.

 

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

 

None.

 

**Item 3. Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5. Other Information**

 

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**Item 6. Exhibits**

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

 

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**SIGNATURES**

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized in the city of Enid, Oklahoma, on the  9th  day of November, 2007.

 
|       | **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/ KEN MAPLES |   |
|       |                       | Ken Maples |
|       | * *                   | *Chief Financial Officer, Vice  President-Finance, Secretary* |
|       | * *                   | *and Director* |

 

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