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** **

**UNITED STATES**

**SECURITIES 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 MARCH 31, 2009** |
|                                                    |
| **OR**                                                  |
|                                                    |
| **o**                                                   | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**FOR THETRANSITION PERIOD FROM              TO              **

 

**Commissionfile number:  001-33018**

 

**Hiland Holdings GP, LP**

(Exact name ofRegistrant as specified in its charter)

 

| **DELAWARE**                              | ** ** | **76-0828238**       |
|-------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer     |
| incorporation or  organization)           |       | Identification  No.) |
|                                      |       |                 |
| **205  West Maple, Suite 1100**      |       |                 |
| **Enid,  Oklahoma**                       | ** ** | **73701**            |
| (Address of  principal executive offices) |       | (Zip Code)           |

 

**(580)242-6040**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.     x   Yes    o  No

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files).       Yes   x    No     ̈

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the ExchangeAct).  o  Yes  x  No

 

The number of the registrant’s outstanding equity units as of May 5,2009 was 21,607,500 common units.

 

 

 

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**HILAND HOLDINGS GP, LP**

 

**INDEX**

 
| **PART I. FINANCIAL INFORMATION**                                                              |
|-----------------------------------------------------------------------------------------------------|
| Item  1. Financial Statements (Unaudited, except December 31, 2008 Balance  Sheet)             |
| Consolidated  Balance Sheets                                                                        |
| Consolidated  Statements of Operations                                                              |
| Consolidated Statements of Comprehensive Income                                                     |
| Consolidated Statements of Cash Flows                                                               |
| Consolidated Statement of Changes in Partners’ Equity                                          |
| Condensed Notes to Consolidated Financial Statements  (Unaudited)                                   |
| 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                                                        |

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Balance Sheets**

**(inthousands, except unit amounts)**

 
| ** **                                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| ** **                                                    | ** ** | **(unaudited)**    | ** ** | ** **            | ** ** |
| **ASSETS**                                                    |       |               |       |                  |       |
| **Current assets:**                                           |       |               |       |                  |       |
| Cash and cash equivalents                                     |       | $                  | 4,091      |                  | $          | 1,733 |   |
| Accounts receivable:                                          |       |               |       |                  |       |
| Trade - net of allowance for doubtful accounts of  $304       |       | 17,093             |       | 23,864                |       |
| Affiliates                                                    |       | 2,579              |       | 2,346                 |       |
|                                                          |       | 19,672             |       | 26,210                |       |
| Fair value of derivative assets                               |       | 8,852              |       | 6,851                 |       |
| Other current assets                                          |       | 1,829              |       | 1,936                 |       |
| Total current assets                                          |       | 34,444             |       | 36,730                |       |
|                                                          |       |               |       |                  |       |
| Property and equipment, net                                   |       | 351,544            |       | 349,159               |       |
| Intangibles, net                                              |       | 39,241             |       | 40,780                |       |
| Fair value of derivative assets                               |       | 5,869              |       | 7,141                 |       |
| Other assets, net                                             |       | 1,599              |       | 1,750                 |       |
|                                                          |       |               |       |                  |       |
| **Total assets**                                              |       | $                  | 432,697    |                  | $          | 435,560 |   |
|                                                          |       |               |       |                  |       |
| **LIABILITIES AND PARTNERSHIP EQUITY**                        | ** ** | ** **         | ** ** | ** **            | ** ** |
| **Current liabilities:**                                      |       |               |       |                  |       |
| Accounts payable                                              |       | $                  | 16,870     |                  | $          | 22,833 |   |
| Accounts payable-affiliates                                   |       | 3,784              |       | 7,823                 |       |
| Fair value of derivative liabilities                          |       | 1,210              |       | 1,439                 |       |
| Accrued liabilities and other                                 |       | 5,815              |       | 3,168                 |       |
| Total current liabilities                                     |       | 27,679             |       | 35,263                |       |
|                                                          |       |               |       |                  |       |
| Commitments and contingencies (Note 9)                        |       |               |       |                  |       |
| Long-term debt                                                |       | 268,294            |       | 256,466               |       |
| Asset retirement obligation                                   |       | 2,512              |       | 2,483                 |       |
|                                                          |       |               |       |                  |       |
| **Partners’ equity:**                                    |       |               |       |                  |       |
| Common unitholders (21,607,500 units issued and  outstanding) |       | 7,361              |       | 12,386                |       |
| Accumulated other comprehensive income                        |       | 5,807              |       | 5,233                 |       |
| Total limited partners’ equity                           |       | 13,168             |       | 17,619                |       |
| Noncontrolling partners’ interest in Hiland Partners     |       | 121,044            |       | 123,729               |       |
| Total partners’ equity                                   |       | 134,212            |       | 141,348               |       |
|                                                          |       |               |       |                  |       |
| **Total liabilities and partners’ equity**               |       | $                  | 432,697    |                  | $          | 435,560 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Statements of Operations**

**Forthe Three Months Ended (Unaudited)**

**(inthousands, except per unit amounts)**

** **
| ** **                                                                       | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                       | ** ** | **2009**           | ** ** | **2008**           | ** ** |
| **Revenues:**                                                                    | ** ** | ** **         | ** ** | ** **         | ** ** |
| Midstream operations                                                             |       |               |       |               |       |
| Third parties                                                                    |       | $                  | 50,111     |               | $          | 89,253 |   |
| Affiliates                                                                       |       | 1,032              |       | 1,021              |       |
| Compression services, affiliate                                                  |       | 1,205              |       | 1,205              |       |
| Total revenues                                                                   |       | 52,348             |       | 91,479             |       |
|                                                                             |       |               |       |               |       |
| **Operating costs and expenses:**                                                | ** ** | ** **         | ** ** | ** **         | ** ** |
| Midstream purchases (exclusive of items shown separately below)                  | ** ** | 17,771             | ** ** | 42,451             | ** ** |
| Midstream purchases -affiliate (exclusive of items  shown separately below)      |       | 13,445             |       | 26,167             |       |
| Operations and maintenance                                                       |       | 7,695              |       | 6,769              |       |
| Depreciation, amortization and accretion                                         |       | 10,258             |       | 9,216              |       |
| Property impairments                                                             |       | 950                |       | —             |       |
| General and administrative                                                       |       | 3,827              |       | 2,684              |       |
| Total operating costs and expenses                                               |       | 53,946             |       | 87,287             |       |
| Operating (loss) income                                                          |       | (1,598             | )          | 4,192              |       |
| **Other income (expense):**                                                      | ** ** | ** **         | ** ** | ** **         | ** ** |
| Interest and other income                                                        |       | 13                 |       | 104                |       |
| Amortization of deferred loan costs                                              |       | (171               | )          | (156               | )          |
| Interest expense                                                                 |       | (2,357             | )          | (3,506             | )          |
| Other income (expense), net                                                      |       | (2,515             | )          | (3,558             | )          |
| **Net (loss) income**                                                            |       | (4,113             | )          | 634                |       |
| Less: Noncontrolling partners’ interest in (loss) income of Hiland Partners | ** ** | (1,214             | )          | (206               | )          |
| **Limited partners’ interest in net (loss) income**                         |       | $                  | (2,899     | )                  | $          | 840 |   |
| ** **                                                                       | ** ** | ** **         | ** ** | ** **         | ** ** |
| **Net (loss) income per limited partners’ unit -  basic**                   |       | $                  | (0.13      | )                  | $          | 0.04 |   |
| **Net (loss) income per limited partners’ unit -  diluted**                 |       | $                  | (0.13      | )                  | $          | 0.04 |   |
| **Weighted average limited partners’ units  outstanding - basic**           | ** ** | 21,608             | ** ** | 21,603             | ** ** |
| **Weighted average limited partners’ units  outstanding - diluted**         | ** ** | 21,608             | ** ** | 21,609             | ** ** |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedStatements of Comprehensive Income**

**For the Three Months Ended (Unaudited)**

**(in thousands)**

 
| ** **                                                                           | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                           | ** ** | **2009**           | ** ** | **2008**           | ** ** |
| Net (loss) income                                                                    |       | $                  | (4,113     | )                  | $          | 634 |   |
| Closed derivative transactions reclassified to  income                               |       | (1,708             | )          | 2,055              |       |
| Change in fair value of derivatives                                                  |       | 2,282              |       | (2,516             | )          |
| Comprehensive (loss) income                                                          |       | $                  | (3,539     | )                  | $          | 173 |   |
| Less: Comprehensive loss attributable to noncontrolling  interest in Hiland Partners |       | (981               | )          | (400               | )          |
| Comprehensive (loss) income attributable to limited  partners                        |       | $                  | (2,558     | )                  | $          | 573 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Statements of Cash Flows**

**Forthe Three Months Ended (Unaudited)**

**(inthousands)**

** **
| ** **                                                                                             | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                             | ** ** | **2009**           | ** ** | **2008**           | ** ** |
| **Cash flows from operating activities:**                                                              |       |               |       |               |       |
| Net (loss) income                                                                                      |       | $                  | (4,113     | )                  | $          | 634 |   |
| Adjustments to reconcile net (loss) income to net  cash provided by operating activities:              |       |               |       |               |       |
| Depreciation and amortization                                                                          |       | 10,219             |       | 9,184              |       |
| Accretion of asset retirement obligation                                                               |       | 39                 |       | 32                 |       |
| Property impairments                                                                                   |       | 950                |       | —             |       |
| Amortization of deferred loan cost                                                                     |       | 171                |       | 156                |       |
| Loss (gain) on derivative transactions                                                                 |       | (384               | )          | 401                |       |
| Unit based compensation                                                                                |       | 356                |       | 409                |       |
| Increase in other assets                                                                               |       | (11                | )          | (91                | )          |
| (Increase) decrease in current assets:                                                                 |       |               |       |               |       |
| Accounts receivable - trade                                                                            |       | 6,770              |       | (5,569             | )          |
| Accounts receivable - affiliates                                                                       |       | (233               | )          | 80                 |       |
| Other current assets                                                                                   |       | 107                |       | (1,310             | )          |
| Increase (decrease) in current liabilities:                                                            |       |               |       |               |       |
| Accounts payable                                                                                       |       | (2,307             | )          | 3,665              |       |
| Accounts payable - affiliates                                                                          |       | (4,038             | )          | 2,681              |       |
| Accrued liabilities and other                                                                          |       | 2,641              |       | 473                |       |
| **Net cash provided by operating activities**                                                          |       | 10,167             |       | 10,745             |       |
| **Cash flows from investing activities:**                                                              |       |               |       |               |       |
| Purchases of property and equipment                                                                    |       | (15,683            | )          | (10,403            | )          |
| Proceeds from disposals of property and equipment                                                      |       | —             |       | 6                  |       |
| **Net cash used in investing activities**                                                              |       | (15,683            | )          | (10,397            | )          |
| **Cash flows from financing activities:**                                                              |       |               |       |               |       |
| Proceeds from long-term borrowings                                                                     |       | 12,000             |       | 9,000              |       |
| Increase in deferred offering cost                                                                     |       | —             |       | (7                 | )          |
| Debt issuance costs                                                                                    |       | (9                 | )          | (317               | )          |
| Proceeds from Hiland Partners, LP unit options  exercise                                               |       | 1                  |       | 611                |       |
| Distributions held in trust refunded to Hiland  Partners on forfeited unvested restricted common units |       | 12                 |       | —             |       |
| Payments on capital lease obligations                                                                  |       | (165               | )          | (107               | )          |
| Cash distributions to noncontrolling partners of  Hiland Partners, LP                                  |       | (1,803             | )          | (3,134             | )          |
| Cash distributions to unitholders                                                                      |       | (2,162             | )          | (5,513             | )          |
| **Net cash provided by financing activities**                                                          |       | 7,874              |       | 533                |       |
|                                                                                                   |       |               |       |               |       |
| Increase for the period                                                                                |       | 2,358              |       | 881                |       |
| Beginning of period                                                                                    |       | 1,733              |       | 10,602             |       |
| **End of period**                                                                                      |       | $                  | 4,091      |               | $          | 11,483 |   |
| Supplementary information                                                                              |       |               |       |               |       |
| Cash paid for interest, net of amounts capitalized                                                     |       | $                  | 2,460      |               | $          | 3,226 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedStatement of Changes in Partners’ Equity**

**For the Three Months Ended March 31, 2009(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                   | ** ** | ** **      | ** ** | ** **        | ** ** | **Noncontrolling**   | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|----------------------|------------|------------|------------|
| ** **                                                                                                   | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | **Partners’**   | ** ** | ** ** | ** ** |
| ** **                                                                                                   | ** ** | ** **      | ** ** | **Other**         | ** ** | **Interest in** | ** ** | ** ** | ** ** |
| ** **                                                                                                   | ** ** | **Common**      | ** ** | **Comprehensive** | ** ** | **Hiland**           | ** ** | ** ** | ** ** |
| ** **                                                                                                   | ** ** | **Unitholders** | ** ** | **Income**        | ** ** | **Partners**         | ** ** | **Total**  | ** ** |
|                                                                                                         |       |            |       |              |       |                 |       |       |       |
| Balance, January 1, 2009                                                                                |       | $               | 12,386     |              | $          | 5,233                |       | $          | 123,729    |   | $ | 141,348 |   |
| Periodic cash distributions                                                                                  |       | (2,162          | )          | —            |       | (1,803               | )          | (3,965     | )          |
| Unit based compensation                                                                                      |       | 36              |       | —            |       | 320                  |       | 356        |       |
| Distributions held in trust refunded to Hiland Partners  on 2,750 forfeited unvested restricted common units |       | —          |       | —            |       | 12                   |       | 12         |       |
| Other comprehensive income reclassified to income on  closed derivative transactions                         |       | —          |       | (1,708            | )          | —               |       | (1,708     | )          |
| Change in fair value of derivatives                                                                          |       | —          |       | 2,282             |       | —               |       | 2,282      |       |
| Net loss                                                                                                     |       | (2,899          | )          | —            |       | (1,214               | )          | (4,113     | )          |
| Balance March 31, 2009                                                                                  |       | $               | 7,361      |              | $          | 5,807                |       | $          | 121,044    |   | $ | 134,212 |   |

 

The accompanying notes are an integral part of this consolidatedfinancial statement.

 

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**HILANDHOLDINGS GP, LP**

**CONDENSED NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (UNAUDITED)**

 

**THREEMONTHS ENDED MARCH 31, 2009 and 2008**

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

 

**Note 1: Organization, Basis of Presentationand Principles of Consolidation**

 

Unless the context requires otherwise, references to “we”, “us,” “our,”“Hiland Holdings” or the “Partnership” are intended to mean the consolidatedbusiness and operations of Hiland Holdings GP, LP. References to “HilandPartners” are intended to mean the consolidated business and operations ofHiland Partners, LP and its subsidiaries.

 

Hiland Holdings GP, LP, a Delaware limited partnership, was formed in May 2006to own Hiland Partners GP, LLC, the general partner of Hiland Partners, LP, andcertain other common and subordinated units in Hiland Partners. Hiland PartnersGP, LLC was formed in October 2004 to hold the 2% general partnerownership interest in Hiland Partners and serve as its general partner. HilandPartners GP, LLC manages the operations of Hiland Partners. In connection withthe closing of our initial public offering, all of the membership interests inHiland Partners GP, LLC were contributed to us. Hiland Partners GP, LLCconstitutes our predecessor.

 

Our general partner, Hiland Partners GP Holdings, LLC manages ouroperations and activities, including, among other things, paying our expensesand establishing the quarterly cash distribution levels for our common unitsand reserves that our general partner determines, in good faith, are necessaryor appropriate to provide for the conduct of our business, to comply withapplicable law, any of our debt instruments or other agreements or to providefor future distributions to our unitholders for any one or more of the upcomingfour quarters.

 

Hiland Partners, a Delaware limited partnership, was formed in October 2004to acquire and operate certain midstream natural gas plants, gathering systemsand compression and water injection assets located in the states of Oklahoma,North Dakota, Wyoming, Texas and Mississippi that were previously owned byContinental Gas, Inc. (“CGI”) and Hiland Partners, LLC. HilandPartners commenced operations on February 15, 2005, and concurrently withthe completion of its initial public offering, CGI contributed a substantialportion of its net assets to Hiland Partners. The transfer of ownership of netassets from CGI to Hiland Partners represented a reorganization of entitiesunder common control and was recorded at historical cost. CGI was formed in1990 as a wholly owned subsidiary of Continental Resources, Inc. (“CLR”).

 

CGI operated in one segment, midstream, which involved the purchasing,gathering, compressing, dehydrating, treating, processing and marketing ofnatural gas and fractionating and marketing of natural gas liquids, or NGLs.CGI historically has owned all of Hiland Partners’ natural gas gathering,processing, treating and fractionation assets other than the Worland,  Bakken, Kinta Area and Woodford Shalegathering 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, consisting of certain southeastern Montana gathering assets, for$92.7 million, $35.0 million of which was used to retire outstandingHiland Partners, LLC indebtedness. On May 1, 2006, Hiland Partnersacquired the Kinta Area gathering assets from Enogex Gas Gathering, L.L.C.,consisting of certain eastern Oklahoma gas gathering assets, for $96.4million.  Hiland Partners financed thisacquisition with $61.2 million of borrowings from its credit facility and $35.0million of proceeds from the issuance to Hiland Partners GP, LLC, its generalpartner, of 761,714 common units and 15,545 general partner equivalent units,both at $45.03 per unit. Hiland Partners began construction of the WoodfordShale gathering system in the first quarter of 2007 and commenced initialstart-up of its operations in April 2007. As of March 31, 2009,Hiland Partners has invested approximately $40.2 million in the Woodford Shalegathering system.  Hiland Partners beganconstruction of the North Dakota Bakken gathering system in the fourth quarterof 2008 and commenced initial start-up of its operations in April 2009. Asof March 31, 2009, Hiland Partners has invested approximately $18.9million in the North Dakota Bakken gathering system.

 

The unaudited financial statements for the three months ended March 31,2009 and 2008 included herein have been prepared pursuant to the rules andregulations of the United States Securities and Exchange Commission (the “SEC”).The interim financial statements reflect all adjustments, which in the opinion ofour management, are necessary for a fair presentation of our results for theinterim periods. Such adjustments are considered to be of a normal recurringnature. Results of operations for the three months ended March 31, 2009are not necessarily indicative of the results of operations that will berealized for the year ending December 31, 2009.  The accompanying consolidated financialstatements and notes thereto should be read in conjunction with theconsolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2008.

 

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***Principlesof Consolidation***

 

Because we own the general partner of Hiland Partners, the consolidatedfinancial statements include our accounts, the accounts of Hiland Partners GP,LLC and the accounts of Hiland Partners and its subsidiaries. All significantintercompany transactions and balances have been eliminated.

 

***Use of Estimates***

 

The preparation of financial statements in accordance with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying notes. Actual results could differfrom those estimates.

 

***Concentration and Credit Risk***

 

Financial instruments that potentially subjectus to concentrations of credit risk consist principally of cash and cashequivalents and receivables.  HilandPartners places cash and cash equivalents with high-quality institutions and inmoney market funds. Hiland Partners derives its revenue from customers primarilyin the oil and gas and utility industries. These industry concentrations havethe potential to impact Hiland Partners’ overall exposure to credit risk,either positively or negatively, in that its customers could be affected bysimilar changes in economic, industry or other conditions. However, we believethat the credit risk posed by this industry concentration is offset by thecreditworthiness of Hiland Partners’ customer base. Hiland Partners’ portfolioof accounts receivable is comprised primarily of mid-size to large domesticcorporate entities.  The counterpartiesto Hiland Partners’ commodity based derivative instruments as of March 31,2009 were BP Energy Company and Bank of Oklahoma, N.A.  The counterparty to Hiland Partners’ interestrate swap as of March 31, 2009 is Wells Fargo Bank, N.A.

 

***Fair Value of FinancialInstruments***

 

Our financial instruments, which require fair value disclosure, consistprimarily of cash and cash equivalents, accounts receivable, financialderivatives, accounts payable and long-term debt. The carrying value of cashand cash equivalents, accounts receivable and accounts payable are consideredto be representative of their respective fair values, due to the short maturityof these instruments. Derivative instruments are reported in the accompanyingconsolidated financial statements at fair value in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 133, “Accounting forDerivative Instruments and Hedging Activities,” as amended (“SFAS 133”). Fairvalue of our derivative instruments is determined based on management estimatesthrough utilization of market data including forecasted forward natural gas andNGL prices as a function of forward New York Mercantile Exchange (“NYMEX”)natural gas and light crude prices and forecasted forward interest rates as afunction of forward London Interbank Offered Rate (“LIBOR”) interest rates. Thefair value of long-term debt approximates its carrying value due to thevariable interest rate feature of such debt.

 

***Interest Rate Risk Management***

 

Hiland Partners is exposed to interest rate risk on its variable ratebank credit facility. Hiland Partners manages a portion of the interest rateexposure by utilizing an interest rate swap to convert a portion of variablerate debt into fixed rate debt. The swap fixes the one month LIBOR rate at theindicated rates for a specified amount of related debt outstanding over theterm of the swap agreement. Hiland Partners has elected to designate theinterest rate swap as a cash flow hedge for SFAS 133 accounting treatment.Accordingly, unrealized gains and losses relating to the interest rate swap arerecorded in accumulated other comprehensive income until the related interestrate expense is recognized in earnings. Any ineffective portion of the gain orloss is recognized in earnings immediately.

 

***Commodity Risk Management***

 

Hiland Partners engages in price risk management activities in order tominimize the risk from market fluctuation in the prices of natural gas andNGLs. To qualify as an accounting hedge, the price movements in the commodityderivatives must be highly correlated with the underlying hedged commodity.Gains and losses related to commodity derivatives that qualify as accountinghedges are recognized in income when the underlying hedged physical transactioncloses and are included in the consolidated statement of operations as revenuesfrom midstream operations. Gains and losses related to commodity derivativesthat are not designated as accounting hedges or do not qualify as accountinghedges are recognized in income immediately and are included in revenues frommidstream operations in the consolidated statement of operations.

 

SFAS 133 establishes accounting and reporting standards for derivativeinstruments, including certain derivative instruments embedded in othercontracts, and for hedging activities. SFAS 133 requires that an entityrecognize all derivatives as either assets or liabilities in the statement offinancial position and measure those instruments at fair value. However, if aderivative does qualify for hedge accounting, depending on the nature of thehedge, changes in fair value can be offset against the change in fair value ofthe 

 

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hedged itemthrough earnings or recognized in other comprehensive income until such time asthe hedged item is recognized in earnings. To qualify for cash flow hedgeaccounting, the cash flows from the hedging instrument must be highly effectivein offsetting changes in cash flows due to changes in the underlying item beinghedged. In addition, all hedging relationships must be designated, documentedand reassessed periodically. SFAS 133 also provides that normal purchases andnormal sales contracts are not subject to the statement. Normal purchases andnormal sales are contracts that provide for the purchase or sale of somethingother than a financial instrument or derivative instrument that will bedelivered in quantities expected to be used or sold by the reporting entityover a reasonable period in the normal course of business.

 

Currently, Hiland Partners’ derivative financial instruments thatqualify for hedge accounting are designated as cash flow hedges. The cash flowhedge instruments hedge the exposure of variability in expected future cashflows that is attributable to a particular risk. The effective portion of thegain or loss on these derivative instruments is recorded in accumulated othercomprehensive income in partners’ equity and reclassified into earnings in thesame period in which the hedged transaction closes. The assets or liabilitiesrelated to the derivative instruments are recorded on the balance sheet as fairvalue of derivative assets or liabilities. Any ineffective portion of the gainor loss is recognized in earnings immediately.

 

***Long Lived Assets***

 

In accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”, Hiland Partners evaluatesits long-lived assets of identifiable business activities for impairment whenevents or changes in circumstances indicate, in management’s judgment, that thecarrying value of such assets may not be recoverable. The determination ofwhether impairment has occurred is based on management’s estimate ofundiscounted future cash flows attributable to the assets as compared to thecarrying value of the assets. If impairment has occurred, the amount of theimpairment recognized is determined by estimating the fair value of the assetsand recording a provision for loss if the carrying value is greater than thefair value. For assets identified to be disposed of in the future, the carryingvalue of these assets is compared to the estimated fair value less the cost tosell to determine if impairment is required. Until the assets are disposed of,an estimate of the fair value is re-determined when related events orcircumstances change.

 

When determining whether impairment of one ofHiland Partners’ long-lived assets has occurred, Hiland Partners must estimatethe undiscounted future cash flows attributable to the asset or asset group.The estimate of cash flows is based on assumptions regarding the volume ofreserves providing asset cash flow and future NGL product and natural gasprices. The amount of reserves and drilling activities are dependent in part oncrude oil and natural gas prices. Projections of reserves and future commodityprices are inherently subjective and contingent upon a number of variablefactors, including, but not limited to:

 

·   changes in general economicconditions in regions in which the Partnership’s assets are located;

·   the availability and pricesof NGLs and NGL products and competing commodities;

·   the availability and pricesof raw natural gas supply;

·   our ability to negotiatefavorable marketing agreements;

·   the risks that third partyoil and gas exploration and production activities will not occur or besuccessful;

·   our dependence on certainsignificant customers and producers of natural gas; and

·   competition from othermidstream service providers and processors, including major energy companies.

 

Any significant variance in any of the aboveassumptions or factors could materially affect our cash flows, which couldrequire us to record an impairment of an asset.

 

In March 2009, as a result of volumes declines at natural gasgathering systems located in Texas and Mississippi, combined with significantlyreduced natural gas prices, Hiland Partners recognized impairment charges of$950.  No impairment charges were recognizedduring the comparable period in 2008.

 

***Net Income (Loss) per LimitedPartners’ Unit***

 

Net income (loss) per limited partners’ unit is computed based on theweighted-average number of common units outstanding during the period. Thecomputation of diluted net income (loss) per limited partner unit furtherassumes the dilutive effect of restricted units. Net income (loss) per limitedpartners’ unit is computed by dividing net income (loss) applicable to limitedpartners by both the basic and diluted weighted-average number of limitedpartnership units outstanding.

 

***Noncontrolling Partners’ Interestin Hiland Partners***

 

The noncontrolling partners’ interest in Hiland Partners presented inpartners’ equity on our consolidated balance sheets as of March 31, 2009and December 31, 2008 reflects the outside ownership interest of HilandPartners. This noncontrolling partners’ interest in Hiland Partners presentedas “Minority interests” in the mezzanine section of the balance sheet at December 31,2008 has been reclassified to the partners’ equity section on the consolidatedbalance sheet in accordance with SFAS No. 160, “Noncontrolling 

 

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Interests inConsolidated Financial Statements — an amendment of ARB No. 51” (“SFAS 160”).The noncontrolling partners’ interest in income (loss) of Hiland Partners iscalculated by multiplying the noncontrolling partners’ proportionate ownershipof limited partner units in Hiland Partners by the limited partners’ allocationof Hiland Partners’ net income (loss). Hiland Partners’ net income (loss) isallocated to its limited partners and its general partner based on theproportionate share of the cash distributions declared for the period, withadjustments made for incentive distributions specifically allocated to itsgeneral partner. All amounts we have received from Hiland Partners’ issuanceand sale of limited partner units have been recorded as increases to thenoncontrolling partners’ interest in Hiland Partners in the partners’ equitysection on the consolidated balance sheet.

 

***Contributions to Subsidiary***

 

The Partnership directly and indirectly owns all of the equityinterests in Hiland Partners GP, LLC, the general partner of Hiland Partners.Hiland Partners GP, LLC is required to make contributions to Hiland Partnerseach time Hiland Partners issues common units in order to maintain its 2%general partner ownership in Hiland Partners. Hiland Holdings was required tocontribute $1 and $12 for the three months ended March 31, 2009 and 2008,respectively.

 

***Recent Accounting Pronouncements***

 

On April 1, 2009, the Financial Accounting Standards Board (“FASB”)issued Staff Position No. FAS 141(R)-1, “Accounting for Assets Acquiredand Liabilities Assumed in a Business Combination That Arise from Contingencies”(“FSP141(R)-1”).  FSP 141(R)-1 amends andclarifies SFAS 141, revised 2007, “Business Combinations” to addressapplication issues on initial and subsequent recognition, measurement,accounting and disclosure of assets and liabilities arising from contingenciesin a business combination.  FSP 141(R)-1is effective for assets and liabilities arising from contingencies in businesscombinations for which the acquisition date is on or after the first annualreporting period beginning on or after December 15, 2008. FSP 141(R)-1 wasadopted effective January 1, 2009 and did not have a material impact onour financial statements and disclosures therein.

 

On April 25, 2008, the FASB issued Staff Position No. FAS142-3, “Determination of the UsefulLife of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that an entityshould consider in developing renewal or extension assumptions used indetermining the useful life of recognized intangible assets under FASBStatement No. 142 (“SFAS 142”), “Goodwilland Other Intangible Assets”. In determining the useful life of anacquired intangible asset, FSP 142-3 removes the requirement from SFAS 142 foran entity to consider whether renewal of the intangible asset requiressignificant costs or material modifications to the related arrangement. FSP142-3 also replaces the previous useful life assessment criteria with arequirement that an entity considers its own experience in renewing similararrangements. If the entity has no relevant experience, it would considermarket participant assumptions regarding renewal.  FSP 142-3 was adoptedeffective January 1, 2009 and will apply to future business combinations.

 

On March 19, 2008, the FASB issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities”, an amendment of SFAS 133(“SFAS 161”). SFAS 161 is intended to improve transparency in financialreporting by requiring enhanced disclosures of an entity’s derivativeinstruments and hedging activities and their effects on the entity’s financialposition, financial performance, and cash flows. SFAS 161 is effectiveprospectively for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008, with early applicationencouraged. SFAS 161 encourages, but does not require, comparative disclosuresfor periods prior to its initial adoption. SFAS 161 amended the qualitative andquantitative disclosure requirements for derivative instruments and hedgingactivities set forth in SFAS 133 and generally increased the level ofaggregation/disaggregation required in an entity’s financial statements. SFAS161 was adopted effective January 1, 2009 and did not have a materialimpact on our financial statements and disclosures therein.

 

On March 12, 2008, the Emerging Issues Task Force (“EITF”) reachedconsensus opinion on EITF Issue 07-4, “Application of the two-class methodunder FASB Statement No. 128, Earnings per Share, to Master LimitedPartnerships” (“EITF 07-4”), which the FASB ratified at its March 26, 2008meeting.  EITF 07-4 requires thecalculation of a Master Limited Partnership’s (“MLPs”) net earnings per limitedpartner unit for each period presented according to distributions declared andparticipation rights in undistributed earnings as if all of the earnings forthat period had been distributed. In periods with undistributed earnings abovespecified levels, the calculation per the two-class method results in anincreased allocation of such undistributed earnings to the general partner anda dilution of earnings to the limited partners. EITF 07-4 is effective for fiscal years beginning after December 15,2008, and is to be applied retrospectively to all periods presented.  EITF 07-4 was adopted effective January 1,2009 and did not have a significant impact on our financial statements anddisclosures therein.

 

In December 2007, the FASB issued SFAS No. 141(R), “BusinessCombinations” (“SFAS 141(R)”). SFAS 141(R) amends and replaces SFAS 141,but retains the fundamental requirements in SFAS 141 that the purchase methodof accounting be used for all business combinations and an acquirer beidentified for each business combination. SFAS 141(R) provides for how theacquirer recognizes and measures the identifiable assets acquired, liabilitiesassumed and any noncontrolling interest in the acquiree. SFAS 141(R) providesfor how the acquirer recognizes and measures the goodwill acquired in thebusiness combination or a gain from a bargain purchase. SFAS 141(R) alsodetermines what information to disclose to enable users to be able to evaluatethe nature 

 

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and financialeffects of the business combination. The provisions of SFAS 141(R) applyprospectively to business combinations for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008. SFAS 141(R) was adopted effective January 1, 2009 and willapply to future business combinations.

 

 In February 2007, the FASBissued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities” (“SFAS 159”). SFAS 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. SFAS159 is effective for fiscal years beginning after November 15, 2007. SFAS159 was adopted effective January 1, 2008, at which time no financialassets or liabilities, not previously required to be recorded at fair value byother authoritative literature, were designated to be recorded at fairvalue.  As such, the adoption of SFAS 159did not have any impact on our financial position, results of operations orcash flows.

 

In September 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (“SFAS 157”).  SFAS 157defines fair value as the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date, establishes a framework for measuring fair value ingenerally accepted accounting principles (“GAAP”) such as fair value hierarchyused to classify the source of information used in fair value measurements(i.e., market based or non-market based) and expands disclosure about fairvalue measurements based on their level in the hierarchy.  SFAS 157 applies to derivatives and otherfinancial instruments, which SFAS 133 requires be measured at fair value atinitial recognition and for all subsequent periods. SFAS 157 establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.SFAS 157’s hierarchy defines three levels of inputs that may be used to measurefair value. Level 1 refers to assets that have observable market prices, level2 assets do not have an “observable price” but do have inputs that are based onsuch prices in which components have observable data points and level 3 refersto assets in which one or more of the inputs do not have observable prices andcalibrated model parameters, valuation techniques or management’s assumptionsare used to derive the fair value. SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. We elected to implement SFAS 157prospectively in the first quarter of 2008 with the one-year deferral permittedby FASB Staff Position (FSP) 157-2 for nonfinancial assets andnonfinancial liabilities measured at fair value, except those that arerecognized or disclosed on a recurring basis (at least annually). The deferralapplies to nonfinancial assets and liabilities measured at fair value in abusiness combination; impaired properties, plants and equipment; intangibleassets and goodwill; and initial recognition of asset retirement obligationsand restructuring costs for which we use fair value. SFAS 157 was adoptedeffective January 1, 2009 and did not have a material impact on ourfinancial statements.  See Note 6 “FairValue Measurements.”

 

In December 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51”(“SFAS 160”). SFAS 160 establishes accounting and reporting standards thatrequire the ownership interests in subsidiaries held by parties other than theparent (minority interest) be clearly identified, labeled and presented in theconsolidated balance sheet within equity, but separate from the parent’sequity. SFAS 160 requires the equity amount of consolidated net incomeattributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated income statement andthat changes in a parent’s ownership interest while the parent retains itscontrolling financial interest in its subsidiary be accounted for consistentlyand similarly as equity transactions. Consolidated net income and comprehensiveincome are now determined without deducting minority interest; however,earnings-per-share information continues to be calculated on the basis of thenet income attributable to the parent’s shareholders.  Additionally, SFAS 160 establishes a singlemethod for accounting for changes in a parent’s ownership interest in asubsidiary that does not result in deconsolidation and that the parentrecognize a gain or loss in net income when a subsidiary isdeconsolidated.  SFAS 160 is effectivefor fiscal years beginning on or after December 15, 2008. SFAS 160 wasadopted effective January 1, 2009 and did not have a material impact onour financial position, results of operations or cash flows.

 

Certain adjustments have been made to prior period information toconform to current period presentation related to our adoption of SFAS 160,which establishes new accounting and reporting standards for the noncontrollingpartners’ interest in Hiland Partners.  Specifically, SFAS 160 requiresthe recognition of a noncontrolling interest (minority interests) as equity inthe consolidated financial statements and separate from our limited partners’equity.  The amount of net income attributable to the noncontrollinginterest will now be included in consolidated net income on the face of thestatement of operations.  SFAS 160 also includes expanded disclosurerequirements regarding our limited partners’ interest and the noncontrollingpartners’ interest.  The adoption of SFAS 160 on January 1, 2009 didnot have a significant impact on our financial position, results of operationsor cash flows.  However, it did result in certain changes to our financialstatement presentation, including the change in classification ofnoncontrolling interest (minority interests) from liabilities to equity on theconsolidated balance sheet.

 

Upon adoption of SFAS 160 effective January 1, 2009, wereclassified $125,851 from minority interests liabilities to noncontrollingpartners’ interest in Hiland Partners, of which $123,729 is a separatecomponent of equity and $2,122 is an increase to accumulated othercomprehensive income, also a component of equity, in our consolidated balancesheet as of December 31, 2008.  In addition, we reclassified $209 ofminority interest in loss of Hiland Partners to net loss attributable tononcontrolling partners’ interest 

 

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in loss of HilandPartners in our consolidated statement of operations for the three months endedMarch 31, 2008.  Net income per limited partner unit has not beenaffected as a result of the adoption of SFAS 160.

 

**Note 2: RecentEvents**

 

On April 20, 2009, the conflicts committee of theboard of directors of the general partner of each of the Partnership and HilandPartners received a letter from Harold Hamm amending his January 15, 2009proposal to acquire all of the outstanding common units of each of thePartnership and Hiland Partners that are not owned by Mr. Hamm, hisaffiliates or Hamm family trusts.  Underthe revised terms proposed by Mr. Hamm, the Partnership unitholders wouldreceive $2.40 in cash per common unit, reduced from $3.20 in cash per commonunit under the January 15, 2009 proposal. Hiland Partners unitholders would receive $7.75 in cash per common unit,reduced from $9.50 in cash per common unit under the January 15, 2009proposal.  Other than the reduced mergerconsideration, Mr. Hamm has not modified the original proposals.Consummation of each transaction is conditioned upon the consummation of theother and subject to the approval of a majority of the public unitholders ofeach of the Partnership and Hiland Partners. The proposals contemplate a merger of each of the Partnership and HilandPartners with a separate new acquisition vehicle to be formed by Mr. Hammand the Hamm family trusts.  Mr. Hammis the Chairman of the board of directors of the general partner of each of thePartnership and Hiland Partners.  Mr. Hamm,either individually or together with his affiliates or the Hamm family trusts,beneficially owns 100% of Hiland Partners GP Holdings, LLC, the general partnerof the Partnership, and approximately 61% of the outstanding common units ofthe Partnership.  The Partnership owns100% of Hiland Partners’ outstanding subordinated units and approximately 37%of Hiland Partners’ outstanding common units.

 

The conflicts committee of the board of directors of the generalpartner of each of the Partnership and Hiland Partners is considering theproposals and any potential alternative available to each of the Partnershipand Hiland Partners.  In reviewing theproposals and potential available alternatives, each conflicts committee hasretained its own financial advisers and legal counsel to assist in its work.Each conflicts committee of the boards of directors is reviewing its respectiveproposal and no decisions have been made by either conflicts committee ofeither board of directors with respect to the response of either us or HilandPartners to the proposals.  There can beno assurance that any agreement will be executed or that any transaction willbe approved or consummated.

 

Two unitholderclass action lawsuits were recently filed in the Court of Chancery of the Stateof Delaware challenging the proposal made by Mr. Hamm to acquire all ofthe outstanding common units of each of the Partnership and Hiland Partnersthat are not owned by Mr. Hamm, his affiliates or Hamm family trusts.

 

On May 1, 2009, a unitholder of the Partnership and HilandPartners filed a complaint alleging claims on behalf of (i) a purportedclass of common unitholders of the Partnership and (ii) a purported classof common unitholders of Hiland Partners against the Partnership, HilandPartners, the general partner of each of the Partnership and Hiland Partners,and the members of the board of directors of each of the Partnership and HilandPartners. The complaint alleges, among other things, that the originalconsideration and revised consideration offered by Mr. Hamm is unfair andinadequate, that the board of directors of the general partner of each of thePartnership and Hiland Partners cannot be expected to act independently, andthat Mr. Hamm and the management of the Partnership and Hiland Partnershave manipulated their public statements to depress the price of the commonunits of the Partnership and Hiland Partners. The plaintiffs seek to enjoin thePartnership, Hiland Partners, and their respective board members fromproceeding with any transaction that may arise from Mr. Hamm’s goingprivate proposal, along with compensatory damages.

 

On February 26, 2009, a unitholder of the Partnership and HilandPartners filed a complaint alleging claims on behalf of a purported class ofcommon unitholders of the Partnership and Hiland Partners against thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and certain members of the board of directors of each ofthe Partnership and Hiland Partners.  Thecomplaint alleges, among other things, that the consideration offered is unfairand grossly inadequate, that the conflicts committee of the board of directorsof the general partner of each of the Partnership and Hiland Partners cannot beexpected to act independently, and that the management of the Partnership andHiland Partners has manipulated its public statements to depress the price ofthe common units of the Partnership and Hiland Partners.

 

The plaintiffs in each lawsuit seek to enjoin the Partnership, HilandPartners, and their respective board members from proceeding with anytransaction that may arise from Mr. Hamm’s going private proposal, alongwith compensatory damages.  We cannotpredict the outcome of these lawsuits, or others, nor can we predict the amountof time and expense that will be required to resolve the lawsuits.

 

**Note 3: Propertyand Equipment and Asset Retirement Obligations**

 

Property and equipment consisted of the following forthe periods indicated:

 

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| ** **                                      | ** ** | **As of**     | ** ** | **As of**        | ** ** |
|-------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Land                                            |       | $                  | 295        |                  | $          | 295 |   |
| Construction in progress                        |       | 21,563             |       | 15,583                |       |
| Midstream pipeline, plants and compressors      |       | 416,205            |       | 410,330               |       |
| Compression and water injection equipment       |       | 19,418             |       | 19,391                |       |
| Other                                           |       | 4,754              |       | 4,621                 |       |
|                                            |       | 462,235            |       | 450,220               |       |
| Less: accumulated depreciation and amortization |       | 110,691            |       | 101,061               |       |
|                                            |       | $                  | 351,544    |                  | $          | 349,159 |   |

 

During the three months ended March 31, 2009 and 2008, wecapitalized interest of $62 and $131, respectively. Hiland Partners recognized$950 of property impairment charges related to natural gas gathering systems inTexas and Mississippi during the three months ended March 31, 2009. HilandPartners incurred no impairment charges during the three months ended March 31,2008.

 

In accordance with SFAS No. 143, “Accounting for Asset RetirementObligations” (“SFAS 143”), we have recorded the fair value of liabilities forasset retirement obligations in the periods in which they are incurred andcorresponding increases in the carrying amounts of the related long-livedassets. The asset retirement costs are subsequently allocated to expense usinga systematic and rational method and the liabilities are accreted to measurethe change in liability due to the passage of time. The provisions of SFAS 143primarily apply to dismantlement and site restoration of certain of HilandPartners’ plants and pipelines. We have evaluated its asset retirementobligations as of March 31, 2009 and have determined that revisions in thecarrying values are not necessary at this time.

 

The following table summarizes our activity related to asset retirementobligations for the indicated period:

 
| Asset retirement obligation, January 1, 2009 |   | $   | 2,483  |   |
|---------------------------------------------------|--------|-----|--------|--------|
| Less: obligation extinguished                     |   | (10 | )      |
| Add: accretion expense                            |   | 39  |   |
| Asset retirement obligation, March 31, 2009  |   | $   | 2,512  |   |

 

**Note 4:   Intangible Assets**

 

Intangible assets consist of the acquired value of customerrelationships, existing contracts to purchase, gather and sell natural gas andother NGLs and compression contracts, which do not have significant residualvalue. The customer relationships and the contracts are being amortized overtheir estimated lives of ten years. We review intangible assets for impairmentwhenever events or circumstances indicate that the carrying amounts may not berecoverable. If such a review should indicate that the carrying amount ofintangible assets is not recoverable, we reduce the carrying amount of suchassets to fair value based on the discounted probable cash flows of theintangible assets. No impairments of intangible assets were recorded during thethree months ended March 31, 2009 or 2008.

 

Intangible assets consisted of the following for the periods indicated:

 
| ** **                    | ** ** | **As of**     | ** ** | **As of**        | ** ** |
|-------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                    | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| 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 |       | 22,330             |       | 20,791                |       |
| Intangible assets, net        |       | $                  | 39,241     |                  | $          | 40,780 |   |

 

During each of the three months ended March 31, 2009 and 2008, werecorded $1,539 of amortization expense. Estimated aggregate amortizationexpense for the remainder of 2009 is $4,619 and $6,157 for each of the foursucceeding fiscal years from 2010 through 2013 and a total of $9,994 for allyears thereafter.

 

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**Note 5: Derivatives**

 

***InterestRate Swap***

 

Hiland Partners is subject tointerest rate risk on its credit facility and has entered into an interest rateswap to reduce this risk. Hiland Partners entered into a one year interest rateswap agreement with its counterparty on October 7, 2008 for the periodfrom January 2009 through December 2009 at a rate of 2.245% on anotional amount of $100.0 million. The swap fixes the one month LIBOR rateat 2.245% for the notional amount of debt outstanding over the term of the swapagreement.  During the three months endedMarch 31, 2009, one month LIBOR interest rates were lower than thecontracted fixed interest rate of 2.245%. Consequently, Hiland Partners incurred additional interest expense of$443 upon monthly settlements of the interest rate swap agreement.

 

The following table provides information about Hiland Partners’ interestrate swap at March 31, 2009 for the periods indicated:

 
| ** **                           | ** ** | ** **   | ** ** | ** **   | ** ** | **Fair Value** | ** ** |
|--------------------------------------|------------|--------------|------------|--------------|------------|---------------------|------------|
| ** **                           | ** ** | **Notional** | ** ** | **Interest** | ** ** | **Asset**           | ** ** |
| **Description and Period** | ** ** | **Amount**   | ** ** | **Rate**     | ** ** | **(Liability)**     | ** ** |
| Interest Rate Swap                   |       |         |       |         |       |                |       |
| April 2009 - December 2009 |       | $            | 100,000    |         | 2.245      | %                   | $          | (1,210 | ) |
|                                      |            |              |            |              |            |                     |            |  |  |

 

***CommoditySwaps***

 

Hiland Partners has entered intocertain derivative contracts that are classified as cash flow hedges inaccordance with SFAS 133 which relate to forecasted natural gas sales in2009 and 2010. At December 31, 2008, the mark-to-market cash flowderivative related to forecasted natural gas sales in 2010 did not qualify forcash flow hedge accounting.  In January 2009,Hiland Partners entered into derivative contracts related to the sameforecasted natural gas sales in 2010 whereby Hiland Partners receives afloating NYMEX index price less fixed differentials and pays a floating pricebased on a Colorado Interstate Gas (“CIG”) index price for the same relevantvolumes and contract period as the underlying natural gas is sold.  The coupled derivative contracts for naturalgas sales in 2010 qualify for cash flow hedge accounting in accordance withSFAS 133 for the remainder of their respective contract periods.  Hiland Partners entered into these financialswap instruments to hedge forecasted natural gas sales against the variabilityin expected future cash flows attributable to changes in commodity prices.Under these swap agreements with its counterparties, Hiland Partners receives afixed price and pays a floating price based on certain indices for the relevantcontract period as the underlying natural gas is sold.

 

Hiland Partners formally documents all relationshipsbetween hedging instruments and the items being hedged, including its riskmanagement objective and strategy for undertaking the hedging transactions.This includes matching the natural gas futures, the “sold fixed for floatingprice” or “buy fixed for floating price” contracts, to the forecastedtransactions. Hiland Partners assesses, both at the inception of the hedge andon an ongoing basis, whether the derivatives are highly effective in offsettingchanges in the fair value of hedged items. Highly effective is deemed to be acorrelation range from 80% to 125% of the change in cash flows of thederivative in offsetting the cash flows of the hedged transaction. If it isdetermined that a derivative is not highly effective as a hedge or it hasceased to be a highly effective hedge, due to the loss of correlation betweenchanges in natural gas reference prices under a hedging instrument and actualnatural gas prices, Hiland Partners will discontinue hedge accounting for thederivative and subsequent changes in fair value for the derivative will berecognized immediately into earnings. Hiland Partners assesses effectivenessusing regression analysis and ineffectiveness using the dollar offset method.

 

Derivatives are recorded on our consolidated balancesheet as assets or liabilities at fair value. For derivatives qualifying ashedges, the effective portion of changes in fair value is recognized inpartners’ equity as accumulated other comprehensive income (loss) andreclassified to earnings when the underlying hedged physical transactioncloses. The ineffective portions of qualifying derivatives are recognized inearnings as they occur. Actual amounts that will be reclassified will vary as aresult of future changes in prices. Hedge ineffectiveness is recorded in incomewhile the hedge contract is open and may increase or decrease until settlementof the contract. Realized cash gains and losses on closed/settled instrumentsand hedge ineffectiveness are reflected in the contract month being hedged asan adjustment to our midstream revenue.

 

On May 27, 2008, Hiland Partners entered into a financial swapinstrument related to forecasted natural gas sales in 2010 whereby HilandPartners receives a fixed price and pays a floating price based on NYMEX HenryHub index pricing for the relevant contract period as the underlying naturalgas is sold. At December 31, 2008, this financial swap instrument did notqualify for hedge accounting as there was inadequate correlation between NYMEXHenry Hub index prices and actual prices received for the natural gas sold. On January 13,2009 and January 15, 2009, Hiland Partners entered into two derivativecontracts related to forecasted natural gas sales in 2010 whereby HilandPartners receives a floating NYMEX Henry Hub index price less differentials of$2.25 and $2.13, respectively, and pays a CIG index price for the same relevantvolumes and contract period as the underlying natural gas related to the May 27,2008 derivative contract is sold.  Thecoupling of these derivative contracts related to forecasted natural gas salesin 2010 are classified as cash flow hedges in accordance with SFAS 133 for theremainder of their respective contract periods.

 

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The followingtable summarizes Hiland Partners’ activity related to derivative transactionsfor the indicated periods:

 
| ** **                                                                                                        | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                        | ** ** | **March 31,**               | ** ** |
| ** **                                                                                                        | ** ** | **2009**                         | ** ** | **2008** | ** ** |
| Net gains (losses) on closed/settled transactions reclassified  from (to) accumulated other comprehensive income  |       | $                                | 1,708      |   | $ | (2,055 | ) |
| Increases (decreases) in fair values of openderivatives recorded to (from)  accumulatedother comprehensive income |       | $                                | 2,282      |   | $ | 2,516 |   |
| Unrealized non-cash gains (losses) on ineffectiveportions of qualifying derivative  transactions                  |       | $                                | 384        |   | $ | (401 | ) |

 

At March 31, 2009, Hiland Partners’ accumulated othercomprehensive income was $5,807. Of this amount, Hiland Partners anticipates$5,629 will be reclassified to earnings during the next twelve months and $178will be reclassified to earnings in subsequent periods.

 

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

 
| ** **                                       | ** ** | **As of**     | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Fair value of derivative assets - current        |       | $                  | 8,852      |                  | $          | 6,851 |   |
| Fair value of derivative assets - long term      |       | 5,869              |       | 7,141                 |       |
| Fair value of derivative liabilities - current   |       | (1,210             | )          | (1,439                | )          |
| Fair value of derivative liabilities - long term |       | —             |       | —                |       |
| Net fair value of derivatives                    |       | $                  | 13,511     |                  | $          | 12,553 |   |

 

The terms of Hiland Partners’ derivative contracts currently extend asfar as December 2010. Hiland Partners’ counterparties to its commodity-basedderivative instruments are BP Energy Company and Bank of Oklahoma, N.A. Thecounterparty to Hiland Partners’ interest rate swap is Wells Fargo Bank, N.A.

 

The following table provides information about Hiland Partners’commodity derivative instruments at March 31, 2009 for the periodsindicated:

 
| ** **                                           | ** ** | ** **  | ** ** | **Average**          | ** ** | ** **          | ** ** |
|------------------------------------------------------|------------|-------------|------------|----------------------|------------|---------------------|------------|
| ** **                                           | ** ** | ** **  | ** ** | **Fixed**            | ** ** | **Fair Value** | ** ** |
| **Description and Production Period** | ** ** | **Volume**  | ** ** | **Price**            | ** ** | **Asset**           | ** ** |
| ** **                                           | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **          | ** ** |
| Natural Gas - Sold Fixed for Floating Price Swaps    |       |        |       |                 |       |                |       |
| April 2009 - March 2010                    |       | 2,136,000   |       | $                    | 7.55       |                | $          | 8,852 |   |
| April 2010 - December 2010                 |       | 1,602,000   |       | $                    | 8.31       |                | 5,869      |   |
|                                                 |       |        |       |                 |       | $                   | 14,721     |   |

 

**Note 6:   Fair Value Measurements**

 

We adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”)beginning in the first quarter of 2008. We adopted FSP 157-2 for nonfinancial assets and nonfinancialliabilities measured at fair value, except those that are recognized ordisclosed on a recurring basis (at least annually) effective January 1,2009, which applies to nonfinancial assets and liabilities measured at fairvalue in a business combination; impaired properties, plants and equipment;intangible assets and goodwill; and initial recognition of asset retirementobligations and restructuring costs for which we use fair value. SFAS 157defines fair value as the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date, establishes a framework for measuring fair value inGAAP such as fair value hierarchy used to classify the source of informationused in fair value measurements (i.e., market based or non-market based) andexpands disclosure about fair value measurements based on their level in thehierarchy.  SFAS 157 establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.SFAS 157’s hierarchy defines three levels of inputs that may be used to measurefair value. Level 1 refers to assets that have observable market prices, level2 assets do not have an “observable price” but do have inputs that are based onsuch prices in which components have observable data points and level 3 

 

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refers to assetsin which one or more of the inputs do not have observable prices and calibratedmodel parameters, valuation techniques or management’s assumptions are used toderive the fair value.

 

SFAS 133 requires derivatives and other financial instruments bemeasured at fair value at initial recognition and for all subsequentperiods.  We use the fair valuemethodology outlined in SFAS 157 to value assets and liabilities for ouroutstanding fixed price cash flow swap derivative contracts. Valuations of ournatural gas derivative contracts are based on published forward price curvesfor natural gas and, as such, are defined as Level 2 fair value hierarchyassets and liabilities. We value our interest rate-based derivative on acomparative mark-to-market value received from our counterparty. The followingtable represents the fair value hierarchy for Hiland Partners’ assets andliabilities measured at fair value on a recurring basis at March 31, 2009:

 
| ** **                                 | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total**  | ** ** |
|--------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|------------|------------|
| ** **                                 | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | ** ** | ** ** |
| Commodity—based derivative assets     |       | $                | —     |             | $          | 14,721           |       | $          | —     |   | $ | 14,721 |   |
| Interest—based derivative liabilities |       | —           |       | —           |       | (1,210           | )          | (1,210     | )          |
| Total                                      |       | $                | —     |             | $          | 14,721           |       | $          | (1,210     | ) | $ | 13,511 |   |

 

The following table provides a summary of changes inthe fair value of Hiland Partners’ Level 3 interest rate-based derivatives forthe three months ended March 31, 2009:

** **
| Balance, January 1, 2009                    |   | $    | (1,439 | ) |
|--------------------------------------------------|--------|------|--------|---|
| Cash settlements from other comprehensive income |   | 443  |   |
| Change in fair value of derivative               |   | (214 | )      |
| Balance, March 31, 2009                     |   | $    | (1,210 | ) |

 

In accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” Hiland Partners reviewsproperties for impairment when events and circumstances indicate a possibledecline in the recoverability of the carrying value of such property. HilandPartners compares each property’s estimated expected future cash flows to thecarrying amount of the property to determine if the carrying amount isrecoverable. If the carrying amount of the property exceeds its estimatedundiscounted future cash flows, the carrying amount of the property is reducedto its estimated fair value. Fair value may be estimated using comparablemarket data, a discounted cash flow method, or a combination of the two.  In the discounted cash flow method,estimated future cash flows are based on management’s expectations for thefuture and include estimates of future oil and gas reserves, commodity pricesbased on commodity futures price strips as of the date of the estimate,operating and development costs, and a risk-adjusted discount rate.

 

As a result of volumes declines combined with significantly reducednatural gas prices, Hiland Partners determined that carrying amounts totalingapproximately $950 related to natural gas gathering systems located in Texasand Mississippi were not recoverable from future cash flows and, therefore,were impaired at March 31, 2009. Hiland Partners reduced the carrying amounts of these nonrecurring level3 hierarchy assets to their estimated fair values of approximately $249 byusing the discounted cash flow method described above, as comparable marketdata was not available.

 

**Note 7: Long-TermDebt**

 

Long-term debt consisted of the following for the indicated periods:

 
| ** **                                | ** ** | **As of**     | ** ** | **As of**        | ** ** |
|-------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Hiland Partners-revolving credit facility |       | $                  | 264,064    |                  | $          | 252,064 |   |
| Hiland Holdings-revolving credit facility |       | 705                |       | 705                   |       |
| Capital lease obligations                 |       | 4,886              |       | 5,051                 |       |
|                                      |       | 269,655            |       | 257,820               |       |
| Less current portion:                     |       |               |       |                  |       |
| Capital lease obligations                 |       | 656                |       | 649                   |       |
| Hiland Holdings-revolving credit facility |       | 705                |       | 705                   |       |
| Long-term debt                            |       | $                  | 268,294    |                  | $          | 256,466 |   |

 

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***HilandPartners Credit Facility***

 

Hiland Partners borrowing capacity under its senior secured revolvingcredit facility, as amended, is $300 million consisting of a$291 million senior secured revolving credit facility to be used forfunding acquisitions and other capital expenditures, issuance of letters ofcredit and general corporate purposes (the “Acquisition Facility”) and a$9.0 million senior secured revolving credit facility to be used forworking capital and to fund distributions (the “Working Capital Facility”).

 

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

 

Due to the recent decline in natural gas and NGL prices, HilandPartners believes that its cash generated from operations will decrease for theremainder of 2009 relative to comparable periods in 2008. Hiland Partners’senior secured revolving credit facility requires it to meet certain financialtests, including a maximum consolidated funded debt to EBITDA covenant ratio of4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscalquarters following the quarter in which such acquisition or capital expenditureoccurs. Hiland Partners met the permitted capital expenditure requirements forthe four quarter period ended March 31, 2009 and elected to increase theratio to 4.75:1.0 on March 31, 2009. During this step-up period, theapplicable margin with respect to loans under the credit facility increases by35 basis points per annum and the unused commitment fee increases by 12.5 basispoints per annum. Unless this ratio is amended, Hiland Partners’ debt isrestructured or Hiland Partners receives an infusion of equity capital,management expects that Hiland Partners will be in violation of the maximumfunded debt to EBITDA covenant ratio contained in its senior secured revolvingcredit facility as early as the second quarter of 2009.  Management has initiated discussions withcertain lenders under Hiland Partners’ credit facility as to potential ways toaddress the expected covenant violation. While no potential solution has beenagreed to, Hiland Partners would expect that any solution would likely requirethe assessment of fees and increased rates, the infusion of additional equitycapital or the incurrence of subordinated indebtedness by Hiland Partners, andthe suspension of distributions for a certain period of time. There can be noassurance that any such agreement will be reached with the lenders or that anyrequired equity or debt financing will be available to Hiland Partners.

 

Upon the occurrence of an event of default as defined in the creditfacility, the lenders may, among other things, be able to accelerate thematurity of the credit facility and exercise other rights and remedies as setforth in the credit facility.

 

Hiland Partners’ obligations under the credit facility are secured bysubstantially all of its assets and guaranteed by Hiland Partners, and all ofits subsidiaries, other than Hiland Operating, LLC, its operating company,which is the borrower under the credit facility.

 

Indebtedness under Hiland Partners’ credit facility will bear interest,at its option, at either (i) an Alternate Base Rate plus an applicablemargin ranging from 50 to 125 basis points per annum or (ii) LIBOR plus anapplicable margin ranging from 150 to 225 basis points per annum based on itsratio of consolidated funded debt to EBITDA. The Alternate Base Rate is a rateper annum equal to the greatest of (a) the Prime Rate in effect on suchday, (b) the base CD rate in effect on such day plus 1.50% and (c) theFederal Funds effective rate in effect on such day plus  1/2 of 1%. Hiland Partners has elected forthe indebtedness to bear interest at LIBOR plus the applicable margin. A letterof credit fee will be payable for the aggregate amount of letters of creditissued under the credit facility at a percentage per annum equal to 1.0%. Anunused commitment fee ranging from 25 to 50 basis points per annum based on ourratio of consolidated funded debt to EBITDA will be payable on the unusedportion of the credit facility. During the step-up period, the applicablemargin with respect to loans under the credit facility will be increased by 35basis points per annum and the unused commitment fee will be increased by 12.5basis points per annum. At March 31, 2009, the interest rate onoutstanding borrowings from Hiland Partners’ credit facility was 3.15%.

 

Hiland Partners is subject to interest rate risk on its credit facilityand has entered into an interest rate swap to reduce this risk. See Note 5“Derivatives” for a discussion of Hiland Partners’ interest rate swap.

 

The credit facility prohibits Hiland Partners from making distributionsto unitholders if any default or event of default, as defined in the creditfacility, has occurred and is continuing or would result from suchdistributions. In addition, the credit facility contains various covenants thatlimit, among other things, subject to certain exceptions and negotiated “baskets,”Hiland Partners’ ability to incur indebtedness, grant liens, make certainloans, acquisitions and investments, make any material changes to the nature ofits 

 

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business, amendits material agreements, including its Omnibus Agreement, which containsnon-compete and indemnity provisions with affiliates, or enter into a merger,consolidation or sale of assets.

 

The credit facility defines EBITDA as Hiland Partners’ consolidated netincome (loss), plus income tax expense, interest expense, depreciation,amortization and accretion expense, amortization of intangibles andorganizational costs, non-cash unit based compensation expense, and adjustmentsfor non-cash gains and losses on specified derivative transactions and forother extraordinary or non-recurring items.

 

The credit facility limits distributions to Hiland Partners’unitholders to available cash, as defined by the agreement, and borrowings tofund such distributions are only permitted under the revolving working capitalfacility. The revolving working capital facility is subject to an annual “clean-down”period of 15 consecutive days in which the amount outstanding under therevolving working capital facility is reduced to zero.

 

As of March 31, 2009, Hiland Partners had$264.1 million outstanding under this credit facility and was incompliance with its financial covenants.

 

***Hiland Holdings Credit Facility***

 

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

 

The credit facility will mature on September 25, 2009, at whichtime all outstanding amounts thereunder become due and payable.

 

Indebtedness under the credit facility bears interest, at our option,at either (i) an Alternate Base Rate plus an applicable margin rangingfrom 100 to 150 basis points per annum or (ii) LIBOR plus an applicablemargin ranging from 200 to 250 basis points per annum in each case based on ourratio of consolidated funded debt to EBITDA. The Alternate Base Rate is equalto the greatest of (a) the prime rate in effect on such day, (b) thebase CD rate in effect on such day plus 1.50% and (c) the federal fundseffective rate in effect on such day plus 1/2 of 1%. We have elected for the indebtednessto bear interest at LIBOR plus the applicable margin. A letter of credit feewill be payable for the aggregate amount of letters of credit issued under thecredit facility at a percentage per annum equal to 2.0%. A commitment feeranging from 25 to 50 basis points per annum based on our ratio of consolidatedfunded debt to EBITDA will be payable on the average daily unused portion ofthe credit facility for the quarter most recently ended. At March 31,2009, the interest rate on outstanding borrowings from our credit facility was2.55%.

 

The credit facility contains several covenants that, among otherthings, require the maintenance of two financial performance ratios, restrictthe payment of distributions to unitholders, and require financial reports tobe submitted periodically to the financial institutions.

 

The credit facility also contains covenants requiring a maximumconsolidated 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 borrow under the credit facility is limited to thelesser of: (i) 50% of the sum of the value of the Hiland Partners commonand subordinated units and certain other assets held by us and certain of oursubsidiaries at the end of each fiscal quarter and (ii) the maximumavailable amount of the credit facility (currently $25.0 million).  For purposes of this calculation, the valueof (i) the Hiland Partners common units on any date shall be the closingprice for such units as reflected on the NASDAQ National Market on any date and(ii) the Hiland Partners subordinated units on any date shall be deemed toequal 85% of the value of the Hiland Partners common units on such date.  At March 31, 2009, the borrowing basewas $19.8 million.

 

The credit facility prohibits us from making distributions tounitholders if any default or event of default, as defined in the creditfacility, has occurred and is continuing or would result from suchdistributions. In addition, the credit facility contains various covenants thatlimit, among other things, subject to certain exceptions and negotiated “baskets,”our ability to incur indebtedness, grant liens, enter into agreementsrestricting our ability to grant liens on our assets or amend the creditfacility, make certain loans, acquisitions and investments or enter into amerger, consolidation or sale of assets.

 

The credit facility limits distributions to our unitholders to ouravailable cash, as defined in our partnership agreement. Restricted paymentsunder the credit facility are subject to an annual “clean-down” period of 15consecutive days in which the amount outstanding that relates to funding therestricted payments under the credit facility must be reduced to zero.

 

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As of March 31, 2009, we had $0.7 millionoutstanding under this credit facility and were in compliance with ourfinancial covenants. The outstanding $0.7 million, which matures on September 25,2009, is included in accrued liabilities and other in the balance sheet.

 

***Capital Lease Obligations***

 

During the third quarter of 2007, Hiland Partners incurred two separatecapital lease obligations at its Bakken and Badlands gathering systems. Underthe terms of a capital lease agreement for a rail loading facility and anassociated products pipeline at its Bakken gathering system, Hiland Partnershas agreed to repay a counterparty a predetermined amount over a period ofeight years. Once fully paid, title to the leased assets will transfer toHiland Partners no later than the end of the eight-year period commencing fromthe inception date of the lease. Hiland Partners also incurred a capital leaseobligation to a counterparty for the aid to construct several electricsubstations at its Badlands gathering system which, by agreement, will berepaid in equal monthly installments over a period of five years.

 

During the three months ended March 31, 2009 and 2008, HilandPartners made principal payments of $165 and $107, respectively, on the abovedescribed capital lease obligations.  Thecurrent portion of the capital lease obligations presented in the table aboveis included in accrued liabilities and other in the balance sheet.

 

**Note 8:  Share-BasedCompensation**

 

***Hiland Holdings GP, LP Long TermIncentive Plan***

 

Hiland Partners GP Holdings, LLC, the general partner of HilandHoldings, adopted the Hiland Holdings GP, LP Long-Term Incentive Plan for itsemployees and directors of its general partner and employees of its affiliates.The long-term incentive plan consists of three components: unit options,restricted units and phantom units. The long-term incentive plan limits thenumber of units that are permitted to be delivered pursuant to awards to2,160,000 units. The plan is administered by the board of directors of ourgeneral partner or the compensation committee of the board of directors of ourgeneral partner. The plan will expire upon the first to occur of itstermination by the board of directors or the compensation committee, the datewhen no units remain available under the plan for awards or the tenthanniversary of the date the plan is approved by our unitholders. Awards thenoutstanding will continue pursuant to the terms of their grants.

 

The board of directors of our general partner and the compensationcommittee of the board may terminate or amend the long-term incentive plan atany time with respect to any units for which a grant has not yet been made. Ourboard of directors and the compensation committee of the board also have theright to alter or amend the long-term incentive plan or any part of the planfrom time to time, including increasing the number of units that may be grantedsubject to unitholder approval as may be required by applicable law or stockexchange rules. However, no change in any outstanding grant may be made thatwould materially reduce the benefits of the participant without the consent ofthe participant. Restricted common units granted vest and become exercisable inone-fourth increments on the anniversary of the grant date over four years. Arestricted unit is a common unit that is subject to forfeiture, and uponvesting, the grantee receives a common unit that is not subject to forfeiture.Distributions on unvested restricted common units are held in trust by ourgeneral partner until the units vest, at which time the distributions aredistributed to the grantee.

 

As provided for in the long-termincentive plan, each non-employee board member of Hiland Partners GP Holdings,LLC on each anniversary date of the initial reward is entitled to receive anadditional 1,000 restricted common units. We issued no restricted units duringthe three months ended March 31, 2009. Non-cash unit based compensationexpense related to restricted units issued is to be recognized over theirrespective four-year vesting period on the graded vesting attribution method.The following table summarizes information about our restricted units for thethree months ended March 31, 2009.

 
| ** **                       | ** ** | ** ** | ** ** | **Weighted**        | ** ** |
|----------------------------------|------------|------------|------------|---------------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Restricted Units**        | ** ** | **Units**  | ** ** | **Date ($)**   | ** ** |
|                             |       |       |       |                |       |
| Unvested at January 1, 2009 |       | 16,500     |       | $                   | 22.52      |   |
| Granted                          |       | —     |       |                |       |
| Vested                           |       | —     |       |                |       |
| Forfeited                        |       | —     |       |                |       |
| Unvested at March 31, 2009  |       | 16,500     |       | $                   | 22.52      |   |

 

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We recorded non-cash compensation expense related to the restrictedunits of $36 and $35 for the three months ended March 31, 2009 and 2008,respectively. We will record additional non-cash unit based compensationexpense of $181 over the next four years.

 

***Hiland Partners, LP Long TermIncentive Plan***

 

Hiland Partners GP, LLC, the general partner of Hiland Partners,adopted the Hiland Partners, LP Long-Term Incentive Plan for its employees anddirectors of its general partner and employees of its affiliates. The long-termincentive plan currently permits an aggregate of 680,000 of Hiland Partnerscommon units to be issued with respect to unit options, restricted units andphantom units granted under the plan. No more than 225,000 of the 680,000common units may be issued with respect to vested restricted or phantom units.The plan is administered by the compensation committee of Hiland Partners GP,LLC’s board of directors. The plan will continue in effect until theearliest of (i) a date determined by the board of directors of the generalpartner; (ii) the date that common units are no longer available forpayment of awards under the plan; or (iii) the tenth anniversary of theplan.

 

Hiland Partners GP, LLC’s board of directors or compensation committeemay, in their discretion, terminate, suspend or discontinue the long-termincentive plan at any time with respect to any units for which a grant has notyet been made. Hiland Partners GP, LLC’s board of directors or its compensationcommittee also has the right to alter or amend the long-term incentive plan orany part of the plan from time to time, including increasing the number ofunits that may be granted, subject to unitholder approval if required by theexchange upon which the common units are listed at that time. No change in anyoutstanding grant may be made, however, that would materially impair the rightsof the participant without the consent of the participant. Under the unitoption grant agreement, granted options of common units 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. Restricted common units granted vestand become exercisable in one-fourth increments on the anniversary of the grantdate over four years. A restricted unit is a common unit that is subject toforfeiture, and upon vesting, the grantee receives a common unit that is notsubject to forfeiture. Distributions on unvested restricted common units areheld in trust by Hiland Partners’ general partner until the units vest, atwhich time the distributions are distributed to the grantee. Granted phantomcommon units are generally more flexible than restricted units and vestingperiods and distribution rights may vary with each grant. A phantom unit is acommon unit that is subject to forfeiture and is not considered issued until itvests. Upon vesting, holders of phantom units will receive (i) a commonunit that is not subject to forfeiture, cash in lieu of the delivery of suchunit equal to the fair market value of the unit on the vesting date, or acombination thereof, at the discretion of Hiland Partners’ general partner’sboard of directors and (ii) the distributions held in trust, ifapplicable, related to the vested units.

 

*Phantom Units. * On February 4, 2009, 2,500 phantom unitsgranted on February 4, 2008 to Matthew S. Harrison, our Chief FinancialOfficer, vested and Mr. Harrison settled 2,500 phantom units for 2,500common units.  On February 25, 2009,625 phantom units granted on February 25, 2008 to an employee vested andthe employee settled 625 of the phantom units for 625 common units.

 

The following table summarizes information aboutHiland Partners’ phantom units for the three months ended March 31, 2009:

 
| ** **                       | ** ** | ** ** | ** ** | **Weighted**        | ** ** |
|----------------------------------|------------|------------|------------|---------------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Phantom Units**           | ** ** | **Units**  | ** ** | **Date ($)**   | ** ** |
| Unvested at January 1, 2009 |       | 50,794     |       | $                   | 47.74      |   |
| Granted                          |       | —     |       |                |       |
| Vested and converted             |       | (3,125     | )          | $                   | 49.37      |   |
| Forfeited                        |       | (500       | )          | $                   | 48.80      |   |
| Unvested at March 31, 2009  |       | 47,169     |       | $                   | 47.62      |   |

 

During the three months ended March 31, 2009 and2008, Hiland Partners incurred non-cash unit based compensation expense of $244and $279, respectively, related to phantom units. Hiland Partners willrecognize additional expense of $1,211 over the next four years, and theadditional expense is to be recognized over a weighted average period of 2.7years.

 

*Restricted Units.*   HilandPartners issued no restricted units during the three months ended March 31,2009.  On March 13, 2009, Dr. DavidL. Boren, a member of Hiland Partners’ board of directors, resigned and thusforfeited 2,750 restricted units.  Thefollowing table summarizes information about Hiland Partners restricted unitsfor the three months ended March 31, 2009.

 

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| ** **                       | ** ** | ** ** | ** ** | **Weighted**        | ** ** |
|----------------------------------|------------|------------|------------|---------------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Restricted Units**        | ** ** | **Units**  | ** ** | **Date ($)**   | ** ** |
| Unvested at January 1, 2009 |       | 18,500     |       | $                   | 48.73      |   |
| Granted                          |       | —     |       |                |       |
| Vested                           |       | —     |       |                |       |
| Forfeited                        |       | (2,750     | )          | $                   | 46.85      |   |
| Unvested at March 31, 2009  |       | 15,750     |       | $                   | 49.06      |   |

 

Non-cash unit based compensation expense related toHiland Partners restricted units was $75 and $84 for the three months ended March 31,2009 and 2008, respectively. As of March 31, 2009, there was $296 of totalunrecognized cost related to Hiland Partners unvested restricted units. Thiscost is to be recognized over a weighted average period of 2.2 years.

 

*Unit Options.*   The followingtable summarizes information about Hiland Partners’ common unit options for thethree months ended March 31, 2009:

 
| ** **                                         | ** ** | ** ** | ** ** | ** **         | ** ** | **Weighted-**         | ** ** | ** **         | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Weighted**       | ** ** | **Average**           | ** ** | ** **         | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | **Average**        | ** ** | **Remaining**         | ** ** | **Aggregate**      | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | **Exercise**       | ** ** | **Contractual**       | ** ** | **Intrinsic**      | ** ** |
| **Options**                                        | ** ** | **Units**  | ** ** | **Price ($)** | ** ** | **Term (Years)** | ** ** | **Value ($)** | ** ** |
| Outstanding at January 1, 2009                |       | 33,336     |       | $                  | 37.79      |                  |       |               |       |   |
| Granted                                            |       | —     |       |               |       |                  |       |               |       |
| Exercised                                          |       | —     |       |               |       |                  |       |               |       |
| Forfeited or expired                               |       | —     |       |               |       |                  |       |               |       |
| Outstanding and exercisable at March 31, 2009 |       | 33,336     |       | $                  | 37.79      |                  | 6.7        |               | —     |   |
|                                                    |            |            |            |                    |            |                       |            |                    |            |  |  |

 

**Note 9: Commitments and Contingencies**

 

We maintain a defined contribution retirement plan for our employeesunder which we make discretionary contributions to the plan based on apercentage of eligible employees’ compensation. Contributions to the plan are5.0% of eligible employees’ compensation and resulted in expense for the threemonths ended March 31, 2009 and 2008 of $89 and $75, respectively.

 

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

 

Although there are no significant regulatory proceedings in which weare currently involved, periodically we may be a party to regulatoryproceedings. The results of regulatory proceedings cannot be predicted withcertainty; however, our management believes that we presently do not have materialpotential liability in connection with regulatory proceedings that would have asignificant financial impact on our consolidated financial condition, resultsof operations or cash flows.

 

Hiland Partners leases certain equipment, vehicles and facilities underoperating leases, most of which contain annual renewal options. We and HilandPartners also lease office space from a related entity. See Note 11 “RelatedParty Transactions.” Under these lease agreements, rent expense was $843 and$616, respectively, for the three months ended March 31, 2009 and 2008,respectively.

 

Two unitholderclass action lawsuits were recently filed in the Court of Chancery of the Stateof Delaware challenging the proposal made by Mr. Hamm to acquire all ofthe outstanding common units of each of the Partnership and Hiland Partnersthat are not owned by Mr. Hamm, his affiliates or Hamm family trusts.

 

One complaintalleges, among other things, that the original consideration and revisedconsideration offered by Mr. Hamm is unfair and inadequate, that the boardof directors of the general partner of each of the Partnership and HilandPartners cannot be expected to act independently, and that Mr. Hamm andthe management of the Partnership and Hiland Partners have manipulated theirpublic statements to depress the price of the common units of the Partnershipand Hiland Partners. The plaintiffs seek to enjoin the Partnership, HilandPartners, and their respective board members from proceeding with anytransaction that may arise from Mr. Hamm’s going private proposal, alongwith compensatory damages.

 

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The secondcomplaint alleges, among other things, that the consideration offered is unfairand grossly inadequate, that the conflicts committee of the board of directorsof the general partner of each of the Partnership and Hiland Partners cannot beexpected to act independently, and that the management of the Partnership andHiland Partners has manipulated its public statements to depress the price ofthe common units of the Partnership and Hiland Partners.

 

The plaintiffs ineach lawsuit seek to enjoin the Partnership, Hiland Partners, and their respectiveboard members from proceeding with any transaction that may arise from Mr. Hamm’sgoing private proposal, along with compensatory damages. Although we stronglybelieve these lawsuits have no merit, we cannot predict the outcome of thelawsuits, or others, nor can we predict the amount of time and expense thatwill be required to resolve the lawsuits. See Note 2 “Recent Events”.

 

**Note 10: Significant Customers andSuppliers**

 

All of Hiland Partners’ revenues are domestic revenues. The followingtable presents Hiland Partners’ top midstream customers as a percent of totalrevenue for the periods indicated:

 
| ** ** | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|------------|------------|--------------------------------------------------------------------|------------|
| ** ** | ** ** | **2009**                                                           | ** ** | **2008** | ** ** |
| Customer 1 |       | 19                                                                 | %          | 8 | % |
| Customer 2 |       | 17                                                                 | %          | 19 | % |
| Customer 3 |       | 12                                                                 | %          | 7 | % |
| Customer 4 |       | 8                                                                  | %          | 10 | % |
| Customer 5 |       | 6                                                                  | %          | 15 | % |
| Customer 6 |       | 5                                                                  | %          | 21 | % |

 

Customer 2 above is SemStream, L.P., a subsidiary of SemGroup, L.P.,who filed a voluntary petition for reorganization under Chapter 11 of the U.S.Bankruptcy Code on July 22, 2008. On March 20, 2009, Hiland Partners received a good faith depositfrom SemStream, L.P. for $3,000 in lieu of renewing a letter of credit to ourbenefit.  The $3,000 deposit received isincluded in accrued liabilities and other in the balance sheet.

 

All of Hiland Partners’ purchases are from domestic sources. Thefollowing table presents Hiland Partners’ top midstream suppliers as a percentof total midstream purchases for the periods indicated:

 
| ** **                      | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                      | ** ** | **2009**                                                           | ** ** | **2008** | ** ** |
| Supplier 1 (affiliated company) |       | 43                                                                 | %          | 38 | % |
| Supplier 2                      |       | 17                                                                 | %          | 15 | % |
| Supplier 3                      |       | 16                                                                 | %          | 19 | % |

 

**Note 11: Related Party Transactions**

 

Hiland Partners purchases natural gas and NGLs from affiliatedcompanies. Purchases of product from affiliates totaled $13,445 and $26,167 forthe three months ended March 31, 2009 and 2008, respectively. HilandPartners also sells natural gas and NGLs to affiliated companies. Sales ofproduct to affiliates totaled $1,032 and $1,021 for the three months ended March 31,2009 and 2008, respectively. Compression revenues from affiliates were $1,205for each of the three months ended March 31, 2009 and 2008, respectively.

 

Accounts receivable-affiliates of $2,579 at March 31, 2009 include$2,281 from one affiliate for midstream sales. Accounts receivable-affiliatesof $2,346 at December 31, 2008, includes $2,083 from one affiliate formidstream sales.

 

Accounts payable-affiliates of $3,784 at March 31, 2009 include$2,773 due to one affiliate for midstream purchases. Accountspayable-affiliates of $7,823 at December 31, 2008 include $6,682 payableto the same affiliate for midstream purchases.

 

Hiland Partners utilizes affiliated companies to provide services toits plants and pipelines and certain administrative services. The totalexpenditures to these companies were $174 and $152 during the three monthsended March 31, 2009 and 2008, respectively.

 

We and Hiland Partners lease office space under operating leasesdirectly or indirectly from an affiliate. Rent expense associated with theseleases totaled $39 and $38 for the three months ended March 31, 2009 and2008, respectively.

 

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**Note 12: Reportable Segments**

 

Hiland Partners has distinct operating segments for which additionalfinancial information must be reported. Hiland Partners’ operations areclassified into two reportable segments:

 

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

 

(2)     Compression, which is providing aircompression and water injection services for oil and gas secondary recoveryoperations that are ongoing in North Dakota.

 

These business segments reflect the way Hiland Partners manages itsoperations. Hiland Partners’ operations are conducted in the United States.General and administrative costs, which consist of executive management,accounting and finance, operations and engineering, marketing and businessdevelopment, are allocated to the individual segments based on revenues.

 

Hiland Partners’ midstream assets totaled $407,435 at March 31,2009. Assets attributable to Hiland Partners’ compression operations totaled$25,263. All but $27 of the total capital expenditures of $12,015 for the threemonths ended March 31, 2009 was attributable to midstream operations. Allbut $14 of the total capital expenditures of $8,130 for the three months ended March 31,2008 was attributable to midstream operations.

 

The tables below present information for the reportable segments forthe three months ended March 31, 2009 and 2008.

 
| ** **                                                                        | ** ** | **For the Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2009**                                                               | ** ** | **2008** | ** ** |
| ** **                                                                        | ** ** | **Midstream**                                                          | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                                        | ** ** | **Segment**                                                            | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
| ** **                                                                        | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                          |       | $                                                                      | 51,143     |   | $ | 1,205 |   | $ | 52,348 |   | $ | 90,274 |   | $ | 1,205 |   | $ | 91,479 |   |
| Operating costs and expenses:                                                     |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Midstream purchases (exclusive of items shown  separately below)                  |       | 31,216                                                                 |       | — |   | 31,216 |   | 68,618 |   | — |   | 68,618 |   |
| Operations and maintenance                                                        |       | 7,695                                                                  |       | — |   | 7,695 |   | 6,541 |   | 228 |   | 6,769 |   |
| Depreciation and amortization                                                     |       | 10,258                                                                 |       | — |   | 10,258 |   | 8,321 |   | 895 |   | 9,216 |   |
| Property impairments                                                              |       | 950                                                                    |       | — |   | 950 |   | — |   | — |   | — |   |
| General and administrative                                                        |       | 3,739                                                                  |       | 88 |   | 3,827 |   | 2,654 |   | 30 |   | 2,684 |   |
| Total operating costs and expenses                                                |       | 53,858                                                                 |       | 88 |   | 53,946 |   | 86,134 |   | 1,153 |   | 87,287 |   |
| Operating income                                                                  |       | $                                                                      | (2,715     | ) | $ | 1,117 |   | (1,598 | ) | $ | 4,140 |   | $ | 52 |   | 4,192 |   |
| Other income (expense):                                                           |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Interest and other income                                                         |       |                                                                   |       |   |   | 13 |   |   |   |   |   | 104 |   |
| Amortization of deferred loan costs                                               |       |                                                                   |       |   |   | (171 | ) |   |   |   |   | (156 | ) |
| Interest expense                                                                  |       |                                                                   |       |   |   | (2,357 | ) |   |   |   |   | (3,506 | ) |
| Net (loss) income                                                                 |       |                                                                   |       |   |   | 4,113 | ) |   |   |   |   | 634 |   |
| Less: Noncontrolling partners’ interest in (loss)  income of Hiland Partners |       |                                                                   |       |   |   | (1,214 | ) |   |   |   |   | (206 | ) |
| Limited partners’ interest in net (loss) income                              |       |                                                                   |       |   |   | $ | (2,899 | ) |   |   |   |   | $ | 840 |   |

 

**Note 13: Net Income (Loss) per LimitedPartners’ Unit**

 

The computation of basic net income (loss) per limited partners’ unitis based on the weighted-average number of common units outstanding during theperiod. The computation of diluted net income (loss) per unit further assumesthe dilutive effect of restricted units. Net income (loss) per unit applicableto limited partners is computed by dividing net income (loss) applicable tolimited partners by the weighted-average number of limited partnership unitsoutstanding. The following is a reconciliation of the limited partner unitsused in the calculations of net income (loss) per limited partner unit—basicand net income (loss) per limited partner unit—diluted assuming dilution forthe three months ended March 31, 2009 and 2008:

 

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| ** **                                                               | ** ** | **For the Three Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                                                               | ** ** | **2008** | ** ** |
| ** **                                                               | ** ** | **(Loss)**                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | **Income** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **Attributable**                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | **Attributable** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **to Limited**                                                    | ** ** | **Limited** | ** ** | ** ** | ** ** | **to Limited** | ** ** | **Limited** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **Partners**                                                           | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** | **Partners** | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                               | ** ** | **(Numerator)**                                                        | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| (Loss) income per limited partner unit -basic:                           |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| (Loss) income attributable to limited partners                           |       | $                                                                      | (2,899     | ) |   |   | $ | (0.13 | ) | 840 |   |   |   | $ | 0.04 |   |
| Weighted average limited partner units outstanding                       |       |                                                                   |       | 21,607,500 |   |   |   |   |   | 21,603,000 |   |   |   |
| Income (loss) per limited partner unit - diluted:  Restricted units      |       |                                                                   |       | — |   |   |   |   |   | 6,000 |   |   |   |
|                                                                     |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| (Loss) income attributable to limited partners plus  assumed conversions |       | $                                                                      | (2,899     | ) | 21,607,500 |   | $ | (0.13 | ) | $ | 840 |   | 21,609,000 |   | $ | 0.04 |   |
|                                                                          |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the three months ended March 31, 2009, approximately 57,000restricted units were excluded from the computation of diluted earningsattributable to limited partner units because the inclusion of such units wouldhave been anti-dilutive.

 

**Note 14: Partners’ Capital and CashDistributions**

 

***Hiland Holdings***

 

Our unitholders (limited partners) have only limited voting rights onmatters affecting our operations and activities and, therefore, limited abilityto influence our management’s decisions regarding our business. Unitholders didnot select our general partner or elect the board of directors of our generalpartner and effectively have no right to select our general partner or electits board of directors in the future. Unitholders’ voting rights are furtherrestricted by our partnership agreement, which provides that any units held bya person that owns 20% or more of any class of units then outstanding, otherthan the general partner, its affiliates, their transferees and persons who acquiredsuch units with the prior approval of the board of directors of our generalpartner, cannot be voted on any matter. In addition, our partnership agreementcontains provisions limiting the ability of our unitholders to call meetings orto acquire information about our operations, as well as other provisionslimiting a unitholders’ ability to influence the manner or direction of ourmanagement.

 

Our partnership agreement requires that we distribute all of our cashon hand at the end of each quarter, less reserves established at our generalpartner’s discretion. We refer to this as “available cash.” Our onlycash-generating assets are our interests in Hiland Partners from which we mayreceive quarterly distributions. The amount of available cash may be greaterthan or less than the minimum quarterly distributions.

 

On April 27, 2009, we announced the suspension of quarterly cashdistributions beginning with the first quarter distribution of 2009 and HilandPartners announced the suspension of quarterly cash distributions on its commonand subordinated units beginning with the first quarter distribution of 2009due to the impact of lower commodity prices and reduced drilling activity onHiland Partners’ current and projected throughput volumes, midstream segmentmargins and cash flows combined with future required levels of capitalexpenditures and the outstanding indebtedness under Hiland Partners’ seniorsecured revolving credit facility. Under the terms of the Hiland Partnerspartnership agreement, the Hiland Partners common units will carry an arrearageof $0.45 per unit, representing the minimum quarterly distribution to theHiland Partners common units for the first quarter of 2009 that must be paidbefore Hiland Partners can make distributions to the Hiland Partnerssubordinated units. All distributions paid by us to our common unitholders fromJanuary 1, 2008 forward, including amounts paid to affiliate owners, wereas follows (in thousands, except per unit amounts):

 
| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** **          | ** ** |
|--------------------|------------|-----------------------------|------------|---------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Distribution**    | ** ** |
| 02/19/08           |       | $                           | 0.2550     |                | $          | 5,513 |   |
| 05/19/08           |       | 0.2800                      |       | 6,053               |       |
| 08/19/08           |       | 0.3050                      |       | 6,593               |       |
| 11/19/08           |       | 0.3175                      |       | 6,866               |       |
| 02/18/09           |       | 0.1000                      |       | 2,162               |       |
|               |       | $                           | 1.2575     |                | $          | 27,187 |   |

 

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***Hiland Partners***

 

The unitholders (limited partners) of Hiland Partners have only limitedvoting rights on matters affecting its operations and activities and,therefore, limited ability to influence its management’s decisions regardingits business. The Hiland Partners unitholders did not select Hiland PartnersGP, LLC as general partner or elect its board of directors and effectively haveno right to select a general partner or elect its board of directors in thefuture. The Hiland Partners unitholders’ voting rights are further restrictedby Hiland Partners’ partnership agreement, which provides that any units heldby a person that owns 20% or more of any class of units then outstanding, otherthan the general partner, its affiliates, their transferees and persons whoacquired such units with the prior approval of Hiland Partners GP, LLC’s boardof directors, cannot be voted on any matter. In addition, Hiland Partners’partnership agreement contains provisions limiting the ability of itsunitholders to call meetings or to acquire information about its operations, aswell as other provisions limiting a unitholder’s ability to influence themanner or direction of Hiland Partners’ management.

 

Hiland Partners’ partnership agreement requires that it distribute allof its cash on hand at the end of each quarter, less reserves established atHiland Partners GP, LLC’s discretion. Hiland Partners refers to this as “availablecash.” The amount of available cash may be greater than or less than theminimum quarterly distributions described below. In general, Hiland Partnerswill pay any cash distribution made each quarter in the following manner:

 

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

 

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

 

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

 

If cash distributions per unit exceed $0.495 in any quarter, HilandPartners GP, LLC as general partner will receive increasing percentages, up toa maximum of 50% of the cash Hiland Partners distributes in excess of thatamount. Hiland Partners refers to these distributions as “incentivedistributions.”

 

The distributions on the subordinated units may be reduced oreliminated if necessary to ensure the common units receive their minimumquarterly distribution.  Subordinatedunits do not accrue arrearages. The subordination period will extend until thefirst day of any quarter beginning after March 31, 2010 that each of thefollowing tests are met:  distributionsof available cash from operating surplus on each of the outstanding commonunits and subordinated units equaled or exceeded the minimum quarterlydistribution for each of the three consecutive, non-overlapping four-quarterperiods immediately preceding that date; the “adjusted operating surplus” (asdefined in the partnership agreement) generated during each of the threeconsecutive, non-overlapping four-quarter periods immediately preceding thatdate equaled or exceeded the sum of the minimum quarterly distributions on allof the outstanding common units and subordinated units during those periods ona fully diluted basis and the related distribution on the 2% general partnerinterest during those periods; and there are no arrearages in payment of theminimum quarterly distribution on the common units.  In addition, if the tests for ending thesubordination period are satisfied for any three consecutive four quarterperiods ending on or after March 31, 2008, 25% of the subordinated unitswill convert into an equal number of common units.  On May 14, 2008 these tests were met andaccordingly, 1,020,000, or 25%, of the subordinated units converted into anequal number of common units.

 

On April 27, 2009, Hiland Partners announced the suspension ofquarterly cash distributions on its common and subordinated units beginningwith the first quarter distribution of 2009 due to the impact of lowercommodity prices and reduced drilling activity on Hiland Partners’ current andprojected throughput volumes, midstream segment margins and cash flows combinedwith future required levels of capital expenditures and the outstandingindebtedness under Hiland Partners’ senior secured revolving credit facility. Under the terms of the HilandPartners partnership agreement, the Hiland Partners common units carry anarrearage of $0.45 per unit, representing the minimum quarterly distribution tothe Hiland Partners common units for the first quarter of 2009 that must bepaid before Hiland Partners can make distributions to the Hiland Partnerssubordinated units.  We own 3,060,000 ofthe Hiland Partners subordinated units which will not receive a cashdistribution until the distribution arrearage to the Hiland Partners commonunits is paid. Presented below are cash distributions to the Hiland Partnerscommon and subordinated unitholders, including amounts to affiliate owners andregular and incentive distributions to Hiland Partners GP, LLC paid by HilandPartners from January 1, 2008 forward (in thousands, except per unitamounts):

 
| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|--------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
| 02/14/08           |       | $                           | 0.7950     |       | $          | 4,169            |       | $                        | 3,243      |                | $          | 182              |       | $ | 1,492 |   | $ | 9,086 |   |
| 05/14/08           |       | 0.8275                      |       | 4,364      |       | 3,376            |       | 194                      |       | 1,789               |       | 9,723            |       |
| 08/14/08           |       | 0.8625                      |       | 5,446      |       | 2,639            |       | 208                      |       | 2,107               |       | 10,400           |       |
| 11/14/08           |       | 0.8800                      |       | 5,574      |       | 2,694            |       | 214                      |       | 2,268               |       | 10,750           |       |
| 02/13/09           |       | 0.4500                      |       | 2,849      |       | 1,377            |       | 86                       |       | —              |       | 4,312            |       |
|               |       | $                           | 3.8150     |       | $          | 22,402           |       | $                        | 13,329     |                | $          | 884              |       | $ | 7,656 |   | $ | 44,271 |   |

 

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Presented below are cash distributions by Hiland Partners to us andHiland Partners GP, LLC from January 1, 2008 forward (in thousands, exceptper unit amounts):

 
| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|--------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
| 02/14/08           |       | $                           | 0.7950     |       | $          | 1,035            |       | $                        | 3,243      |                | $          | 182              |       | $ | 1,492 |   | $ | 5,952 |   |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
| 05/15/08           |       | 0.8275                      |       | 1,077      |       | 3,376            |       | 194                      |       | 1,789               |       | 6,436            |       |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
| 08/14/08           |       | 0.8625                      |       | 2,003      |       | 2,639            |       | 208                      |       | 2,107               |       | 6,957            |       |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
| 11/14/08           |       | 0.8800                      |       | 2,043      |       | 2,694            |       | 214                      |       | 2,268               |       | 7,219            |       |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
| 02/13/09           |       | 0.4500                      |       | 1,045      |       | 1,377            |       | 86                       |       | —              |       | 2,508            |       |
|               |       |                        |       |       |       |             |       |                     |       |                |       |             |       |
|               |       | $                           | 3.8150     |       | $          | 7,203            |       | $                        | 13,329     |                | $          | 884              |       | $ | 7,656 |   | $ | 29,072 |   |

 

**Note15:   Supplemental Information**

 

Following are the financial statements of Hiland Holdings which areincluded to provide additional information with respect to Hiland Holdings’financial position, results of operations and cash flows on a stand-alonebasis.

 

**HILAND HOLDINGS GP, LP**

**Balance Sheets**

**(inthousands, except unit amounts)**

 
| ** **                                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**    | ** ** | ** **            | ** ** |
| **ASSETS**                                                    |       |               |       |                  |       |
| **Current assets:**                                           |       |               |       |                  |       |
| Cash and cash equivalents                                     |       | $                  | 360        |                  | $          | 561 |   |
| Accounts receivable-affiliates                                |       | —             |       | 2                     |       |
| Other current assets                                          |       | 455                |       | 351                   |       |
| Total current assets                                          |       | 815                |       | 914                   |       |
|                                                          |       |               |       |                  |       |
| Investment in subsidiary                                      |       | (15                | )          | 4,195                 |       |
| Property and equipment, net                                   |       | 3,192              |       | 3,304                 |       |
| Intangibles, net                                              |       | 4,963              |       | 5,138                 |       |
| Other assets, net                                             |       | 44                 |       | 66                    |       |
| **Total assets**                                              |       | $                  | 8,999      |                  | $          | 13,617 |   |
|                                                          |       |               |       |                  |       |
| **LIABILITIES AND PARTNERS’ EQUITY**                     | ** ** | ** **         | ** ** | ** **            | ** ** |
| **Current liabilities:**                                      |       |               |       |                  |       |
| Accounts payable                                              |       | $                  | 761        |                  | $          | 363 |   |
| Accounts payable-affiliates                                   |       | 172                |       | 163                   |       |
| Other current liabilities                                     |       | 705                |       | 705                   |       |
| Total current liabilities                                     |       | 1,638              |       | 1,231                 |       |
|                                                          |       |               |       |                  |       |
| **Partners’ equity**                                     |       |               |       |                  |       |
| Common unitholders (21,607,500 units issued and  outstanding) |       | 7,361              |       | 12,386                |       |
| Total partners’ equity                                   |       | 7,361              |       | 12,386                |       |
|                                                          |       |               |       |                  |       |
| **Total liabilities and partners’ equity**               |       | $                  | 8,999      |                  | $          | 13,617 |   |

 

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**HILANDHOLDINGS GP, LP**

**Statementsof Operations**

**Forthe Three Months Ended (Unaudited)**

**(inthousands)**

 
| ** **                              | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|-----------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                              | ** ** | **2009**           | ** ** | **2008**           | ** ** |
| ** **                              | ** ** | ** **         | ** ** | ** **         | ** ** |
| **Operating costs and expenses:**       | ** ** | ** **         | ** ** | ** **         | ** ** |
| Depreciation and amortization           |       | $                  | (287       | )                  | $          | (287 | ) |
| General and administrative              |       | (887               | )          | (383               | )          |
| Operating loss                          |       | (1,174             | )          | (670               | )          |
| **Other income (expense):**             |       |               |       |               |       |
| Equity in (loss) earnings of affiliates |       | (1,699             | )          | 1,533              |       |
| Interest and other income               |       | 1                  |       | 4                  |       |
| Amortization of deferred loan costs     |       | (22                | )          | (22                | )          |
| Interest expense                        |       | (5                 | )          | (5                 | )          |
| Other income (expense), net             |       | (1,725             | )          | 1,510              |       |
| **Net (loss) income**                   |       | $                  | (2,899     | )                  | $          | 840 |   |

 

**HILANDHOLDINGS GP, LP**

**Statementsof Cash Flows**

**Forthe Three Months Ended (Unaudited)**

**(inthousands)**

 
| ** **                                                                                   | ** ** | **March 31,** | ** ** | **March 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                   | ** ** | **2009**           | ** ** | **2008**           | ** ** |
| **Cash flows from operating activities:**                                                    |       |               |       |               |       |
| Net (loss) income                                                                            |       | $                  | (2,899     | )                  | $          | 840 |   |
| Adjustments to reconcile net income to net cash provided  by (used in) operating activities: |       |               |       |               |       |
| Depreciation and amortization                                                                |       | 287                |       | 287                |       |
| Amortization of deferred loan cost                                                           |       | 22                 |       | 22                 |       |
| Unit based compensation                                                                      |       | 36                 |       | 38                 |       |
| Loss (earnings) in Hiland Partners, LP                                                       |       | 1,699              |       | (1,534             | )          |
| (Increase) decrease in current assets:                                                       |       |               |       |               |       |
| Accounts receivable - affiliates                                                             |       | 2                  |       | 5                  |       |
| Other current assets                                                                         |       | (104               | )          | (230               | )          |
| Increase (decrease) in current liabilities:                                                  |       |               |       |               |       |
| Accounts payable - trade                                                                     |       | 398                |       | 152                |       |
| Accounts payable - affiliates                                                                |       | 9                  |       | 41                 |       |
| Accrued liabilities and other                                                                |       | —             |       | —             |       |
| **Net cash used in operating activities**                                                    |       | (550               | )          | (379               | )          |
| **Cash flows from investing activities:**                                                    |       |               |       |               |       |
| Investment in subsidiaries                                                                   |       | —             |       | (12                | )          |
| Cash distributions received from subsidiaries                                                |       | 2,511              |       | 5,952              |       |
| **Net cash provided by investing activities**                                                |       | 2,511              |       | 5,940              |       |
| **Cash flows from financing activities:**                                                    |       |               |       |               |       |
| Cash distributions to unitholders                                                            |       | (2,162             | )          | (5,513             | )          |
| **Net cash used in financing activities**                                                    |       | (2,162             | )          | (5,513             | )          |
|                                                                                         |       |               |       |               |       |
| Increase (decrease) for the period                                                           |       | (201               | )          | 48                 |       |
| Beginning of period                                                                          |       | 561                |       | 105                |       |
| **End of period**                                                                            |       | $                  | 360        |               | $          | 153 |   |
|                                                                                         |       |               |       |               |       |
| Supplementary information                                                                    |       |               |       |               |       |
| Cash paid for interest                                                                       |       | $                  | 4          |               | $          | 6 |   |

 

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**Note16:   Subsequent Event**

 

On May 1, 2009, a unitholder of the Partnership and HilandPartners filed a complaint alleging claims on behalf of (i) a purportedclass of common unitholders of the Partnership and (ii) a purported classof common unitholders of Hiland Partners against the Partnership, HilandPartners, the general partner of each of the Partnership and Hiland Partners,and the members of the board of directors of each of the Partnership and HilandPartners. The complaint alleges, among other things, that the originalconsideration and revised consideration offered by Mr. Hamm is unfair andinadequate, that the board of directors of the general partner of each of thePartnership and Hiland Partners cannot be expected to act independently, andthat Mr. Hamm and the management of the Partnership and Hiland Partnershave manipulated their public statements to depress the price of the commonunits of the Partnership and Hiland Partners. The plaintiffs seek to enjoin thePartnership, Hiland Partners, and their respective board members fromproceeding with any transaction that may arise from Mr. Hamm’s goingprivate proposal, along with compensatory damages.  See Note 2 “Recent Events” for additionalinformation on litigation related to the going private proposals.

 

On April 20, 2009, the conflicts committee of the board ofdirectors of the general partner of each of the Partnership and Hiland Partnersreceived a letter from Harold Hamm amending his January 15, 2009 proposalto acquire all of the outstanding common units of each of the Partnership andHiland Partners that are not owned by Mr. Hamm, his affiliates or Hammfamily trusts.  Under the revised termsproposed by Mr. Hamm, the Partnership’s unitholders would receive $2.40 incash per common unit, reduced from $3.20 in cash per common unit under the January 15,2009 proposal. Hiland Partners’ unitholders would receive $7.75 in cash percommon unit, reduced from $9.50 in cash per common unit under the January 15,2009 proposal. See Note 2 “Recent Events.”

 

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**CautionaryStatement About Forward-Looking Statements**

 

This report on Form 10-Q includes certain “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934. Thesestatements include statements regarding our plans, goals, beliefs or currentexpectations. Statements using words such as “anticipate,” “believe,” “intend,”“project,” “plan,” “continue,” “estimate,” “forecast,” “may,” “will” or similarexpressions help identify forward-looking statements. Although we believe suchforward-looking statements are based on reasonable assumptions and currentexpectations and projections about future events, no assurance can be giventhat every objective will be reached.

 

Actual results may differ materially from any results projected,forecasted, estimated or expressed in forward-looking statements since many ofthe factors that determine these results are subject to uncertainties andrisks, difficult to predict, and beyond management’s control. Such factorsinclude:

 

·    the ability to comply with the certaincovenants in our or Hiland Partners’ credit facilities and the ability to reachagreement with ours or Hiland Partners’ lenders in the event of a breach ofsuch covenants;

 

·    the ability to pay distributions to ourunitholders;

 

·    our expected receipt of distributions fromHiland Partners;

 

·    Hiland Partners’ cash flow is affected bythe volatility of natural gas and NGL product prices, which could adverselyaffect Hiland Partners ability to make distributions to its unitholders,including us;

 

·    Hiland Partners’ continued ability to findand contract for new sources of natural gas supply;

 

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

 

·    the amount of natural gas transported onHiland Partners’ gathering systems;

 

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

 

·    the fees Hiland Partners charges and themargins realized for its services;

 

·    the prices and market demand for, and therelationship between, natural gas and NGLs;

 

·    energy prices generally;

 

·    the level of domestic oil and natural gasproduction;

 

·    the availability of imported oil and naturalgas;

 

·    actions taken by foreign oil and gasproducing nations;

 

·    the political and economic stability ofpetroleum producing nations;

 

·    the weather in Hiland Partners’ operatingareas;

 

·    the extent of governmental regulation andtaxation;

 

·    hazards or operating risks incidental to thetransporting, treating and processing of natural gas and NGLs that may not befully covered by insurance;

 

·    competition from other midstream companies;

 

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·    loss of key personnel;

 

·    the availability and cost of capital andHiland Partners’ ability to access certain capital sources;

 

·    changes in laws and regulations to which weand Hiland Partners are subject, including tax, environmental, transportationand employment regulations;

 

·    the costs and effects of legal andadministrative proceedings;

 

·    the ability to successfully identify andconsummate strategic acquisitions at purchase prices that are accretive toHiland Partners’ financial results;

 

·    risks associated with the construction ofnew pipelines and treating and processing facilities or additions to HilandPartners’ existing pipelines and facilities;

 

·    the completion of significant, unbudgetedexpansion projects may require debt and/or equity financing which may not beavailable to Hiland Partners on acceptable terms, or at all; and

 

·    increases in interest rates could increaseHiland Partners’ borrowing costs, adversely impact its unit price and itsability to issue additional equity, which could have an adverse effect onHiland Partners’ cash flows and its ability to fund its growth.

 

These factors are not necessarily all of the important factors thatcould cause our actual results to differ materially from those expressed in anyof our forward-looking statements. Our future results will depend upon various otherrisks and uncertainties, including, but not limited to those described above.Other unknown or unpredictable factors also could have material adverse effectson our future results. You should not place undue reliance on anyforward-looking statements.

 

All forward-looking statements attributable to us are qualified intheir entirety by this cautionary statement. We undertake no duty to update ourforward-looking statements to reflect the impact of events or circumstancesafter the date of the forward-looking statements.

 

**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

Unless the context requiresotherwise, 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.

 

**GeneralTrends and Outlook**

 

We expect Hiland Partners’ business to continue to be affected by thefollowing key trends. These expectations are based on assumptions made by usand information currently available to us. To the extent our underlyingassumptions about or interpretations of available information prove to beincorrect, our expectations may vary materially from actual results. Please see“Forward-Looking Statements.”

 

*U.S.Natural Gas Supply and Outlook.*    Natural gas prices have continued todecline significantly since the peak New York Mercantile Exchange (“NYMEX”)Henry Hub last day settle price of $13.11/MMBtu in July 2008 to the NYMEXHenry Hub last day settle price of $3.32 in May 2009.  U.S. natural gas drilling rig counts havedeclined by approximately 50% to 741 as of May 1, 2009, compared to 1,473natural gas drilling rigs in the comparable period of 2008, and approximately54% compared to the peak natural gas drilling rig count of 1,606 in August andSeptember 2008.  We believe thatcurrent natural gas prices will continue to result in reduced naturalgas-related drilling activity as producers seek to decrease their level ofnatural gas production.  We also believethat current reduced natural gas drilling activity will persist until theeconomic environment in the United States improves and increases the demand fornatural gas.

 

*U.S. CrudeOil Supply and Outlook.*   The domestic and globalrecession and resulting drop in demand for crude oil products continues tosignificantly impact the price for crude oil. West Texas Intermediate (WTI)crude oil pricing has declined from a peak of $134.62/bbl in July 2008 toa low of $33.87/Bbl in January 2009, a 74.8% decline.  U.S. crude oil drilling rig counts havedeclined by approximately 45% to 196 as of May 1, 2009, compared to 360crude oil drilling rigs in the comparable period of 2008, and approximately 56%compared to the peak crude oil drilling rig count of 442 in November 2008.  The forward curve for WTI crude oil pricingreflects continued reductions in demand for crude oil. We also believe that currentreduced crude oil drilling activity will persist until the economic environmentin the United States improves and increases the demand for crude oil.

 

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*U.S. NGLSupply and Outlook.*   The domestic and global recession and resulting dropin demand for NGL products has significantly impacted the price for NGLs.  NGL prices have dropped dramatically sincethe peak NGL basket pricing of $2.21/gallon in June 2008 to a March 2009NGL basket pricing of $0.70/gallon, a 68.3% decline.  NGL basket pricing correlates to WTI crudeoil pricing.  WTI crude oil pricing hasdeclined from a peak of $134.62/Bbl in July 2008 to $33.87/Bbl in January 2009,a 74.8% decline.  The forward curve forNGL basket pricing and WTI crude oil pricing reflects continued reductions indemand for NGL products.  We also believethat the current reduced NGL products pricing will persist until the economicenvironment in the United States improves and increases the demand for NGLproducts.

 

A number of the areas in which Hiland Partners operates areexperiencing a significant decline in drilling activity as a result of therecent dramatic decline in natural gas and crude oil prices.  While we anticipate continued exploration andproduction activities in the areas in which Hiland Partners operates, albeit atdepressed levels, fluctuations in energy prices can greatly affect productionrates and investments by third parties in the development of natural gas andoil reserves.  Drilling activitygenerally decreases as natural gas and oil prices decrease.  Hiland Partners has no control over the levelof drilling activity in the areas of its operations.

 

**Disruption to functioning ofcapital markets**

 

Multiple events during 2008and 2009 involving numerous financial institutions have effectively restrictedcurrent liquidity within the capital markets throughout the United States andaround the world. Despite efforts by treasury and banking regulators in theUnited States, Europe and other nations around the world to provide liquidityto the financial sector, capital markets currently remain constrained. Weexpect that ours and Hiland Partners’ ability to raise debt and equity atprices that are similar to offerings in recent years to be limited over thenext three to six months and possibly longer should capital markets remainconstrained.

 

**Overview of Hiland Holdings**

 

We are a Delaware limited partnership formed in May 2006 to ownHiland Partners GP, LLC, the general partner of Hiland Partners, andcertain other common and subordinated units in Hiland Partners.  We reflect our ownership interest in HilandPartners on a consolidated basis, which means that our financial results arecombined with Hiland Partners’ financial results. The noncontrolling partners’interest in income (loss) of Hiland Partners is reflected as an equity amountof consolidated net income (loss) attributable to the noncontrolling partners’interest on our consolidated statements of operations and the ownershipinterests of the noncontrolling partners’ interest in Hiland Partners ispresented within the equity section of our consolidated balance sheets. HilandPartners GP, LLC’s results of operations principally reflect the results ofoperations of Hiland Partners and are adjusted for noncontrolling partners’interests in Hiland Partners’ net income (loss).

 

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

 
| · | the 2% general  partner interest in Hiland Partners;                                                                                            |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------|
| · | 100% of the  incentive distribution rights in Hiland Partners; and                                                                              |
| · | 2,321,471 common  units and 3,060,000 subordinated units of Hiland Partners, representing a  57.5% limited partner interest in Hiland Partners. |

 

Hiland Partners is required by its partnership agreement to distributeall of its cash on hand at the end of each quarter, after establishing reservesto provide for the proper conduct of its business or to provide funds forfuture distributions. Due to (i) the impact of lower commodity prices anddrilling activity on Hiland Partners’ current and projected throughput volumes,midstream segment margin and cash flows; (ii) future required levels ofcapital expenditures; (iii) the level of Hiland Partners’ indebtednessrelative to its projections and (iv) management’s expectation that HilandPartners will be in violation of the maximum funded debt to EBITDA covenantratio contained in its senior secured credit facility at the end of the secondquarter of 2009 unless the ratio is amended, Hiland Partners’ debt isrestructured or Hiland Partners receives an infusion of equity capital, on April 27,2009, Hiland Partners announced the suspension of cash distributions beginningwith the first quarter of 2009.

 

*Cash Distributions.  * On April 27, 2009, Hiland Partnersannounced the suspension of quarterly cash distributions on its common andsubordinated units beginning with the first quarter distribution of 2009 due tothe impact of lower commodity prices and reduced drilling activity on HilandPartners’ current and projected throughput volumes, midstream segment marginsand cash flows combined with future required levels of capital expenditures andthe outstanding indebtedness under Hiland Partners’ senior secured revolvingcredit facility.  Under the terms of theHiland Partners partnership agreement, the Hiland Partners common units carryan arrearage of $0.45 per unit, representing the minimum quarterly distributionto the Hiland Partners common units for the first quarter of 2009 that must bepaid before Hiland Partners can make distributions to the Hiland Partnerssubordinated units.  We own 3,060,000 ofthe Hiland Partners subordinated units which will not receive a cashdistribution until the distribution arrearage to the Hiland 

 

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Partners commonunits is paid. The following table presents Hiland Partners’ distributions paidto us on May 14, 2008 for the three months ended March 31, 2008.

 
| ** **                                                   | ** ** | **Three Months**   | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                   | ** ** | **Ended**          | ** ** |
| ** **                                                   | ** ** | **March 31,** | ** ** |
| **Hiland Partners’ Distributions**                      | ** ** | **2008**           | ** ** |
| Common units                                                 |       | $                  | 1,077      |   |
| Subordinated units                                           |       | 3,376              |       |
| Ownership interest in Hiland Partners’ general  partner |       | 194                |       |
| General partners’ incentive distribution rights         |       | 1,789              |       |
|                                                         |       | $                  | 6,436      |   |

 

Because we own Hiland Partners GP, LLC, the distributions to us includethe distributions made to Hiland Partners GP, LLC.

 

**Overview of Hiland Partners**

 

Hiland Partners is engaged in purchasing, gathering, compressing,dehydrating, treating, processing and marketing of natural gas, fractionatingand marketing of NGLs, and providing air compression and water injectionservices for oil and gas secondary recovery operations. Hiland Partners’operations are primarily located in the Mid-Continent and Rocky Mountainregions of the United States.

 

Hiland Partners manages its business and analyzes and reports itsresults of operations on a segment basis. Hiland Partners’ operations aredivided into two business segments:

 

·    *Midstream Segment,*which is engaged in purchasing, gathering, compressing, dehydrating, treating,processing and marketing of natural gas and the fractionating and marketing ofNGLs. The midstream segment generated 94.3% and 94.7% of total segment marginfor the three months ended March 31, 2009 and 2008, respectively.

 

·    *Compression Segment,*which is engaged in providing air compression and water injection services foroil and gas secondary recovery operations that are ongoing in North Dakota. Thecompression segment generated 5.7% and 5.3% of total segment margin for thethree months ended March 31, 2009 and 2008, respectively.

 

Hiland Partners’ midstream assets currently consist of 15 natural gasgathering systems with approximately 2,138 miles of gas gatheringpipelines, six natural gas processing plants, seven natural gas treatingfacilities and three NGL fractionation facilities.  Hiland Partners’ compression assets consistof two air compression facilities and a water injection plant.

 

Hiland Partners’ results of operations are determined primarily by fiveinterrelated variables: (1) the volume of natural gas gathered through itspipelines; (2) the volume of natural gas processed; (3) the volume ofNGLs fractionated; (4) the levels and relationship of natural gas and NGLprices; and (5) Hiland Partners’ current contract portfolio. BecauseHiland Partners’ profitability is a function of the difference between therevenues it receives from its operations, including revenues from the productsit sells, and the costs associated with conducting its operations, includingthe costs of products it purchases, increases or decreases in Hiland Partners’revenues alone are not necessarily indicative of increases or decreases in itsprofitability. To a large extent, Hiland Partners’ contract portfolio, thepricing environment for natural gas and NGLs and the price of NGLs relative tonatural gas prices will dictate increases or decreases in its profitability.Hiland Partners’ profitability is also dependent upon prices and market demandfor natural gas and NGLs, which fluctuate with changes in market and economicconditions and other factors.

 

**Recent Events**

 

*Class Action Lawsuit.* On May 1, 2009, a unitholder of the Partnership and Hiland Partnersfiled a complaint alleging claims on behalf of (i) a purported class ofcommon unitholders of the Partnership and (ii) a purported class of commonunitholders of Hiland Partners against the Partnership, Hiland Partners, thegeneral partner of each of the Partnership and Hiland Partners, and the membersof the board of directors of each of the Partnership and Hiland Partners. Thecomplaint alleges, among other things, that the original consideration andrevised consideration offered by Mr. Hamm is unfair and inadequate, thatthe board of directors of the general partner of each of the Partnership andHiland Partners cannot be expected to act independently, and that Mr. Hammand the management of the Partnership and Hiland Partners have manipulatedtheir public statements to depress the price of the common units of thePartnership and Hiland Partners. The plaintiffs seek to enjoin the Partnership,Hiland Partners, and their respective board 

 

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members from proceeding with any transaction that may arise from Mr. Hamm’sgoing private proposal, along with compensatory damages.

 

*Our Distribution.  *On April 27,2009, we announced the suspension of cash distributions beginning with thefirst quarter of 2009 due to the impact of lower commodity prices and reduceddrilling activity on Hiland Partners’ current and projected throughput volumes,midstream segment margins and cash flows combined with future required levelsof capital expenditures and the outstanding indebtedness under Hiland Partners’senior secured revolving credit facility.

 

*Hiland Partners Distribution.  *On April 27, 2009, Hiland Partners announced thesuspension of quarterly cash distributions on its common and subordinated unitsbeginning with the first quarter distribution of 2009 due to the impact oflower commodity prices and reduced drilling activity on Hiland Partners’current and projected throughput volumes, midstream segment margins and cashflows combined with future required levels of capital expenditures and theoutstanding indebtedness under Hiland Partners’ senior secured revolving creditfacility.  Under the terms of the HilandPartners partnership agreement, the Hiland Partners common units carry anarrearage of $0.45 per unit, representing the minimum quarterly distribution tothe Hiland Partners common units for the first quarter of 2009 that must bepaid before Hiland Partners can make distributions to the Hiland Partnerssubordinated units.  We own 3,060,000 ofthe Hiland Partners subordinated units which will not receive a cashdistribution until the distribution arrearage to the Hiland Partners commonunits is paid.

 

*Going Private Proposals.** *On April 20, 2009, the conflicts committee of theboard of directors of the general partner of each of the Partnership and HilandPartners received a letter from Harold Hamm amending his January 15, 2009proposal to acquire all of the outstanding common units of each of the Partnershipand Hiland Partners that are not owned by Mr. Hamm, his affiliates or Hammfamily trusts.  Under the revised termsproposed by Mr. Hamm, the Partnership unitholders would receive $2.40 incash per common unit, reduced from $3.20 in cash per common unit under the January 15,2009 proposal.  Hiland Partnersunitholders would receive $7.75 in cash per common unit, reduced from $9.50 incash per common unit under the January 15, 2009 proposal.  Other than the reduced merger consideration, Mr. Hammhas not modified the original proposals. Consummation of each transaction isconditioned upon the consummation of the other and subject to the approval of amajority of the public unitholders of each of the Partnership and HilandPartners.  The proposals contemplate amerger of each of the Partnership and Hiland Partners with a separate newacquisition vehicle to be formed by Mr. Hamm and the Hamm familytrusts.  Mr. Hamm is the Chairman ofthe board of directors of the general partner of each of the Partnership andHiland Partners.  Mr. Hamm, eitherindividually or together with his affiliates or the Hamm family trusts,beneficially owns 100% of Hiland Partners GP Holdings, LLC, the general partnerof the Partnership, and approximately 61% of the outstanding common units ofthe Partnership.  The Partnership ownsapproximately 37% of Hiland Partners’ outstanding common units.

 

The conflicts committee of the board of directors of the generalpartner of each of the Partnership and Hiland Partners is considering theproposals and any potential alternative available to each of the Partnershipand Holdings.  In reviewing the proposalsand potential available alternatives, each conflicts committee has retained itsown financial advisers and legal counsel to assist in its work.  The boards of directors of the generalpartners of each of the Partnership and Hiland Partners caution our unitholdersand the unitholders of Hiland Partners, respectively, and others consideringtrading in the securities of the Partnership and Hiland Partners, that eachconflicts committee of the boards of directors is reviewing its respectiveproposal and no decisions have been made by either conflicts committee ofeither board of directors with respect to the response of either us or Hiland Partnersto the proposals.  There can be noassurance that any agreement will be executed or that any transaction will beapproved or consummated.

 

**Historical Results of Operations**

 

Our historical results of operations for the periods presented may notbe comparable, either from period to period or going forward primarily due todecreased natural gas and natural gas liquid prices and significantly increasedvolumes and operating expenses at Hiland Partners’ Woodford Shale and Badlandsgathering systems.

 

**Our Results of Operations**

 

The following table presents a reconciliation of the non-GAAP financialmeasure of total segment margin (which consists of the sum of midstream segmentmargin and compression segment margin) to operating income on a historicalbasis for each of the periods indicated. We view total segment margin, a non-GAAP financial measure, as animportant performance measure of the core profitability of our operationsbecause it is directly related to our volumes and commodity price changes.  We review total segment margin monthly forconsistency and trend analysis.  Wedefine midstream segment margin as midstream revenue less midstreampurchases.  Midstream revenue includesrevenue from the sale of natural gas, NGLs and NGL products resulting from HilandPartners’ gathering, treating, processing and fractionation activities andfixed fees associated with the gathering of natural gas and the transportationand disposal of saltwater.  Midstreampurchases include the cost of natural gas, condensate and NGLs purchased byHiland Partners from third parties, the cost of natural gas, condensate andNGLs purchased by Hiland Partners from affiliates, and the cost of crude oilpurchased by Hiland Partners from third parties. We define compression segmentmargin as the revenue derived from 

 

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Hiland Partners’compression segment. Total segment margin may not be comparable to similarlytitled measures of other companies as other companies may not calculate totalsegment margin in the same manner.

 

The results of our operations discussed below principally reflect theactivities of Hiland Partners. Because our consolidated financial statementsinclude the results of Hiland Partners, our financial statements aresubstantially similar to the financial statements of Hiland Partners. However,the noncontrolling partners’ interest in income (loss) of Hiland Partners isreflected as an equity amount of consolidated net income (loss) attributable tothe noncontrolling limited partners’ interest on our consolidated statements ofoperations and the ownership interests of the noncontrolling partners’ interestin Hiland Partners is presented within the equity section of our consolidatedbalance sheets. The noncontrolling partners’ interest in Hiland Partners is notreflected on Hiland Partners’ consolidated financial statements.

 

Set forth in the tables below are certain financial and operating datafor the periods indicated.

 
| ** **                                                                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                        | ** ** | **2009**                              | ** ** | **2008** | ** ** |
| ** **                                                                        | ** ** | **(in thousands)**                    | ** ** |
| **Total Segment Margin Data:**                                                    | ** ** | ** **                            |       |   |   |
| Midstream revenues                                                                |       | $                                     | 51,143     |   | $ | 90,274 |   |
| Midstream purchases                                                               |       | 31,216                                |       | 68,618 |   |
| Midstream segment margin                                                          |       | 19,927                                |       | 21,656 |   |
| Compression revenues (1)                                                          |       | 1,205                                 |       | 1,205 |   |
| Total segment margin (2)                                                          |       | $                                     | 21,132     |   | $ | 22,861 |   |
|                                                                              |       |                                  |       |   |   |
| **Summary of Operations Data:**                                                   | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Midstream revenues                                                                |       | $                                     | 51,143     |   | $ | 90,274 |   |
| Compression revenues                                                              |       | 1,205                                 |       | 1,205 |   |
| Total revenues                                                                    |       | 52,348                                |       | 91,479 |   |
|                                                                              |       |                                  |       |   |   |
| Midstream purchases (exclusive of items shown  separately below)                  |       | 31,216                                |       | 68,618 |   |
| Operations and maintenance                                                        |       | 7,695                                 |       | 6,769 |   |
| Depreciation, amortization and accretion                                          |       | 10,258                                |       | 9,216 |   |
| Property impairments                                                              |       | 950                                   |       | — |   |
| General and administrative                                                        |       | 3,827                                 |       | 2,684 |   |
| Total operating costs and expenses                                                |       | 53,946                                |       | 87,287 |   |
| Operating (loss) income                                                           |       | (1,598                                | )          | 4,192 |   |
| Other income (expense), net                                                       |       | (2,515                                | )          | (3,558 | ) |
| Net (loss) income                                                                 |       | (4,113                                | )          | 634 |   |
| Less: Noncontrolling partners’ interest in (loss) income  of Hiland Partners |       | (1,214                                | )          | (206 | ) |
| **Limited partners’ interest in net (loss) income**                          |       | $                                     | (2,899     | ) | $ | 840 |   |
|                                                                              |       |                                  |       |   |   |
| **Hiland Partners Operating Data:**                                               |       |                                  |       |   |   |
| Inlet natural gas (Mcf/d)                                                         |       | 276,398                               |       | 227,431 |   |
| Natural gas sales (MMBtu/d)                                                       |       | 91,912                                |       | 85,773 |   |
| NGL sales (Bbls/d)                                                                |       | 7,048                                 |       | 5,272 |   |
|                                                                                   |            |                                       |            |  |  |  |  |  |  |

 

----

(1)    Compression revenues and compression segment marginare the same. There are no compression purchases associated with thecompression segment.

 

(2)                                 Reconciliation of total segment margin tooperating income:

 

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| ** **                                                      | ** ** | **Three Months Ended March 31,** |       |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                      | ** ** | **2009**                              | ** ** | **2008** |   |
| ** **                                                      | ** ** | **(in thousands)**                    |       |
| **Reconciliation of Total Segment Margin to  Operating Income** |       |                                  |       |   |   |
| Operating income                                                |       | $                                     | (1,598     | ) | $ | 4,192 |   |
| Add:                                                            |       |                                  |       |   |   |
| Operations and maintenance expenses                             |       | 7,695                                 |       | 6,769 |   |
| Depreciation, amortization and accretion                        |       | 10,258                                |       | 9,216 |   |
| Property impairments                                            |       | 950                                   |       | — |   |
| General and administrative expenses                             |       | 3,827                                 |       | 2,684 |   |
| Total segment margin                                            |       | $                                     | 21,132     |   | $ | 22,861 |   |

 

**Three Months Ended March 31, 2009 Comparedwith Three Months Ended March 31, 2008**

 

***Revenues.***  Total revenues (midstream and compression) were $52.3 millionfor the three months ended March 31, 2009 compared to $91.5 million forthe three months ended March 31, 2008, a decrease of $39.1 million, or42.8%.  This $39.1 million decrease was primarily due to significantlylower average realized natural gas and NGL sales prices for all of ourgathering systems, partially offset by increased natural gas sales volumes of9,277 MMBtu/d (MMBtu per day) and increased NGL sales volumes of 1,129 Bbls/d(Bbls per day) related to the Woodford Shale gathering system, increasednatural gas sales volumes of 1,307 MMBtu/d and increased NGL sales volumes of 711Bbls/d attributable to the Badlands gathering system and increased natural gassales volumes of 1,673 MMBtu/d and increased NGL sales volumes of 136 Bbls/dattributable to the Matli gathering systems for the three months ended March 31,2009 as compared to the same period in 2008.  Revenues from compressionassets were the same for both periods.

 

Midstream revenues were $51.1 million for the three months ended March 31,2009 compared to $90.3 million for the three months ended March 31, 2008,a decrease of $39.1 million, or (43.4%). Of this $39.1 million decrease in midstream revenues, approximately$52.7 million was attributable to significantly lower average realized naturalgas and NGL sales prices for all of our gathering systems, partially offset byapproximately $13.6 million attributable to revenues from increased natural gasand NGL sales volumes at our Woodford Shale, Badlands and Matli gatheringsystems for the three months ended March 31, 2009 as compared to the sameperiod in 2008.

 

Inlet natural gas was 276,398 Mcf/d (Mcf per day) for the three monthsended March 31, 2009 compared to 227,431 Mcf/d for the three months ended March 31,2008, an increase of 48,967 Mcf/d, or 21.5%. This increase is primarily attributable to volume growth at our WoodfordShale, Badlands, Kinta Area and Matli gathering systems, offset by volumedeclines at our Eagle Chief and Worland gathering systems.

 

Natural gas sales volumes were 91,912 MMBtu/d for the three monthsended March 31, 2009 compared to 85,773 MMBtu/d for the three months endedMarch 31, 2008, an increase of 6,139 MMBtu/d, or 7.2%.  This 6,139MMBtu/d net increase in natural gas sales volumes was attributable to increasednatural gas sales volumes at our Woodford Shale, Matli and Badlands gatheringsystems, offset by reduced natural gas sales volumes at our Eagle Chief, KintaArea and Worland gathering systems.

 

NGL sales volumes were 7,048 Bbls/d for the three months ended March 31,2009 compared to 5,272 Bbls/d for the three months ended March 31, 2008, anet increase of 1,776 Bbls/d, or 33.7%.  This 1,776 Bbls/d net increase inNGL sales volumes is primarily attributable to volume growth at our WoodfordShale, Badlands and Matli gathering systems, offset by reduced NGL salesvolumes at our Eagle Chief, Bakken and Worland gathering systems.

 

Average realized natural gas sales prices were $3.68 per MMBtu for thethree months ended March 31, 2009 compared to $7.33 per MMBtu for thethree months ended March 31, 2008, a decrease of $3.65 per MMBtu, or (49.8%). Average realized NGL sales prices were $0.57 per gallon for the three monthsended March 31, 2009 compared to $1.40 per gallon for the three monthsended March 31, 2008, a decrease of $0.83 per gallon or (59.3%).  Thedecrease in our average realized natural gas and NGL sales prices was primarilya result of significantly lower index prices for natural gas and posted pricesfor NGLs during the three months ended March 31, 2009 compared to thethree months ended March 31, 2008.

 

Net cash received from our counterparty on cash flow swap contracts fornatural gas sales and natural gas purchase derivative transactions that closedduring the three months ended March 31, 2009 totaled $2.2 million comparedto $0.2 million for the three months ended March 31, 2008.  The $2.2million gain for the three months ended March 31, 2009 increased averagedrealized natural gas prices to $3.68 per MMBtu from $3.42 per MMBtu, anincrease of $0.26 per MMBtu.  The $0.2million net gain for the three months ended March 31, 2008 increasedaveraged realized natural gas prices to $7.33 per MMBtu from $7.31 per MMBtu,an increase of $0.02 per MMBtu. We had no cash flow swap contracts for NGLderivatives during the three months ended March 31, 2009.  Cash 

 

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paid to ourcounterparty on cash flow swap contracts for NGL derivative transactions thatclosed during the three months ended March 31, 2008 totaled $2.2million.  The $2.2 million loss for the three months ended March 31,2008 reduced averaged realized NGL prices to $1.40 per gallon from $1.51 pergallon, a decrease of $0.11 per gallon.

 

Compression revenues were $1.2 million for the each of the three monthsended March 31, 2009 and 2008.

 

***Midstream Purchases.***  Midstream purchases were $31.2 million for thethree months ended March 31, 2009 compared to $68.6 million for the threemonths ended March 31, 2008, a decrease of $37.4 million, or(54.5%).  This $37.4 million decrease is primarily due to significantlyreduced natural gas and NGL purchase prices, resulting in decreased midstreampurchases for all of our gathering systems, partially offset by increasednatural gas and NGL volumes purchased at our Woodford Shale, Badlands and Matligathering systems.

 

***Midstream Segment Margin.***  Midstream segment margin was $19.9 million forthe three months ended March 31, 2009 compared to $21.7 million for thethree months ended March 31, 2008, a decrease of $1.7 million, or(8.0%).  The decrease is primarily due tounfavorable gross processing spreads and significantly lower average realizednatural gas and NGL prices, partially offset by volume growth at the WoodfordShale and Badlands gathering systems and approximately $2.3 million of foregonemargin as a result of the nitrogen rejection plant at the Badlands gatheringsystem being taken out of service due to equipment failure during the threemonths ended March 31, 2008.  As apercent of midstream revenues, midstream segment margin was 39.0% for the threemonths ended March 31, 2009 compared to 24.0% for the three months ended March 31,2008, an increase of 15.0%.  This 15.0%increase is primarily attributable to gains on closed/settled derivativetransactions and unrealized non-cash gains on open derivative transactions forthe three months ended March 31, 2009 totaling $2.4 million compared tonet losses of $2.5 million on closed/settled derivative transactions andunrealized non-cash losses on open derivative transactions for the three monthsended March 31, 2008.

 

***Operations and Maintenance.***  Operations and maintenance expense totaled $7.7million for the three months ended March 31, 2009 compared with $6.8million for the three months ended March 31, 2008, an increase of $0.9million, or 13.7%.  Of this increase,$0.7 million was attributable to increased operations and maintenance at theBadlands gathering system and $0.1 million was attributable to increasedoperations and maintenance at the Woodford Shale gathering system.

 

***Depreciation, Amortization and Accretion.***  Depreciation, amortization andaccretion expense totaled $10.3 million for the three months ended March 31,2009 compared with $9.2 million for the three months ended March 31, 2008,an increase of $1.0 million, or 11.3 %.  This $1.0 million increase wasprimarily attributable to increased depreciation of $0.4 million on theWoodford Shale gathering system, $0.3 million on the Kinta Area gatheringsystem and $0.2 million on the Badlands gathering system.

 

***Property Impairments.***  Property impairment expense related to naturalgas gathering systems in Texas and Mississippi totaled $1.0 million for thethree months ended March 31, 2009. We had no property impairments during the three months ended March 31,2008.

 

***General and Administrative.***  General and administrative expense totaled $3.8million for the three months ended March 31, 2009 compared with $2.7million for the three months ended March 31, 2008, an increase of $1.1million, or 42.6%. Salaries expense increased by $0.2 million as a result ofincreased staffing during the three months ended March 31, 2009 ascompared to the three months ended March 31, 2008.  Expenses related to the going privateproposals were $0.7 million for the three months ended March 31, 2009.

 

***Other Income (Expense).*** Other income (expense) totaled $(2.5) millionfor the three months ended March 31, 2009 compared with $(3.6) million forthe three months ended March 31, 2008, a decrease in expense of $1.0 million. The decrease is primarily attributable lower interest rates incurred during thethree months ended March 31, 2009 compared to interest rates incurredduring the three months ended March 31, 2008, offset by increased interestexpense on additional borrowings related to the construction of the NorthDakota Bakken gathering system.

 

***Noncontrolling Partners’ Interest in Income (Loss) of HilandPartners.  *** Noncontrolling partners’ interest in income (loss) of Hiland Partners,which represents the allocation of Hiland Partners earnings or (loss) to itslimited partner interests not owned by Hiland Holdings, totaled $0.8 millionfor the three months ended March 31, 2009 compared to $0.2 million for thethree months ended March 31, 2008, an increased (loss) of $0.6 million.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

***U.S. Natural Gas, Crude Oil and NGL Supplies andOutlook***

 

The domestic and global recession and resulting drop in demand fornatural gas, crude oil and NGL products continues to significantly impact theprice for natural gas, crude oil and NGLs. Natural gas prices have continued todecline significantly since the peak NYMEX Henry Hub last day settle price of$13.11/MMBtu in July 2008 to the NYMEX Henry Hub last day settle price of$3.32 

 

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in May 2009,a 74.7% decline.  WTI crude oil pricinghas declined from a peak of $134.62/bbl in July 2008 to $33.87/Bbl in January 2009,a 74.8% decline.  NGL basket pricingcorrelates to WTI crude oil pricing. NGL prices have dropped dramatically sincethe peak NGL basket pricing of $2.21/gallon in June 2008 to a March 2009NGL basket pricing of $0.70/gallon, a 68.3% decline.  Forward curves for natural gas, crude oil andNGL basket pricing reflect continued reductions in demand for natural gas,crude oil and NGL products.  We believethat current natural gas, crude oil and NGL prices will continue to result inreduced drilling activity as producers seek to decrease their level of naturalgas and crude oil production. We also believe the decreased drilling activitywill persist until the economic environment in the United States improves andincreases the demand for natural gas, crude oil and NGLs.

 

A number of the areas in which Hiland Partners operates areexperiencing a significant decline in drilling activity as a result of therecent dramatic decline in natural gas and crude oil prices.  While Hiland Partners anticipates continuedexploration and production activities in the areas in which it operates, albeitat depressed levels, fluctuations in energy prices can greatly affectproduction rates and investments by third parties in the development of naturalgas and oil reserves.  Drilling activitygenerally decreases as natural gas and oil prices decrease.  Hiland Partners has no control over the levelof drilling activity in the areas of its operations.

 

***Disruption toFunctioning of Capital Markets***

 

Multiple events during 2008 and 2009 involving numerous financialinstitutions have effectively restricted current liquidity within the capitalmarkets throughout the United States and around the world. Despite efforts bytreasury and banking regulators in the United States, Europe and other nationsaround the world to provide liquidity to the financial sector, capital marketscurrently remain constrained. We expect that our ability to issue debt andequity at prices that are similar to offerings in recent years will be limitedover the next three to six months and possibly longer should capital marketsremain constrained. Although we intend to move forward with our plannedinternal growth projects, we may revise the timing and scope of these projectsas necessary to adapt to existing economic conditions and the benefits expectedto accrue to our unitholders from our expansion activities may be muted bysubstantial cost of capital increases during this period.

 

***Overview***

 

Due to the recent decline in natural gas and NGL prices, Hiland Partnersbelieves that its cash generated from operations will decrease for theremainder of 2009 relative to comparable periods in 2008. Hiland Partners’senior secured revolving credit facility requires it to meet certain financialtests, including a maximum consolidated funded debt to EBITDA covenant ratio of4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscalquarters following the quarter in which such acquisition or capital expenditureoccurs. Hiland Partners met the permitted capital expenditure requirements forthe four quarter period ended March 31, 2009 and elected to increase theratio to 4.75:1.0 on March 31, 2009. During this step-up period, theapplicable margin with respect to loans under the credit facility increases by35 basis points per annum and the unused commitment fee increases by 12.5 basispoints per annum. Unless this ratio is amended, Hiland Partners’ debt isrestructured or Hiland Partners receives an infusion of equity capital,management expects that Hiland Partners will be in violation of the maximumfunded debt to EBITDA covenant ratio contained in its senior secured revolvingcredit facility as early as the second quarter of 2009.  Management has initiated discussions with certainlenders under Hiland Partners’ credit facility as to potential ways to addressthe expected covenant violation. While no potential solution has been agreedto, Hiland Partners would expect that any solution would likely require theassessment of fees and increased rates, the infusion of additional equitycapital or the incurrence of subordinated indebtedness by Hiland Partners, andthe suspension of distributions for a certain period of time. There can be noassurance that any such agreement will be reached with the lenders or that any requiredequity or debt financing will be available to Hiland Partners.

 

We rely on distributions from Hiland Partners to fund cash requirementsfor our operations. Cash generated from operations, borrowings under HilandPartners’ credit facility and funds from private or public equity and futuredebt offerings have historically been Hiland Partners’ primary sources ofliquidity. We believe that funds from these sources should be sufficient tomeet both Hiland Partners’ short-term working capital requirements and itslong-term capital expenditure requirements. Hiland Partners’ ability to paydistributions to unitholders, to fund planned capital expenditures and to makeacquisitions depends upon Hiland Partners’ future operating performance and,more broadly, on the availability of equity and debt financing, which will beaffected by prevailing economic conditions in Hiland Partners’ industry andfinancial, business and other factors, many of which are beyond Hiland Partners’control. Due to (i) the impact of lower commodity prices and drillingactivity on Hiland Partners’ current and projected throughput volumes,midstream segment margin and cash flows; (ii) future required levels ofcapital expenditures; (iii) the level of Hiland Partners’ indebtednessrelative to its projections and (iv) management’s expectation that HilandPartners will be in violation of the maximum funded debt to EBITDA covenantratio contained in its senior secured credit facility at the end of the secondquarter of 2009 unless the ratio is amended, Hiland Partners’ debt isrestructured or Hiland Partners receives an infusion of equity capital, on April 27,2009, Hiland Partners announced the suspension of quarterly cash distributionson common and subordinated units beginning with the first quarter distributionof 2009.

 

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***CashFlows from Operating Activities***

 

Cash flows from operating activities decreased by $0.6 million to $10.2million for the three months ended March 31, 2009 from $10.7 million forthe three months ended March 31, 2008.  During the three months endedMarch 31, 2009 we received cash flows from customers of approximately$58.6 million attributable to significantly lower average realized natural gasand NGL sales prices, partially offset by increased natural gas and NGLsvolumes, made cash payments to our suppliers and employees of approximately$46.0 million and made payments of interest expense of $2.5 million, net ofamounts capitalized, resulting in cash received from operating activities of$10.2 million.  During the same threemonth period in 2008, we received cash flows from customers of approximately$85.2 million attributable to increased natural gas and NGL volumes andsignificantly higher average realized natural gas and NGL sales prices, madecash payments to our suppliers and employees of approximately $71.3 million andmade payments of interest expense of $3.2 million, net of amounts capitalized,resulting in cash received from operating activities of $10.7 million.

 

Changes in cash receipts and payments are primarily due to the timingof collections at the end of our reporting periods. Hiland Partners collectsand pays large receivables and payables at the end of each calendar month. Thetiming of these payments and receipts may vary by a day or two betweenmonth-end periods and cause fluctuations in cash received or paid. Workingcapital items, exclusive of cash, provided $2.9 million of cash flows fromoperating activities during the three months ended March 31, 2009. Workingcapital items, exclusive of cash, was insignificant for the three months ended March 31,2008.

 

Net loss for the three months ended March 31, 2009 was $(2.3)million, a decrease of $3.2 million from a net income of $0.8 million for thethree months ended March 31, 2008.  Depreciation and amortizationincreased by $1.0 million to $10.2 million for the three months ended March 31,2009 from $9.2 million for the three months ended March 31, 2008.

 

***CashFlows Used for Investing Activities***

 

Cash flows used for investing activities, which represent investmentsin property and equipment increased by $5.3 million to $15.7 million for thethree months ended March 31, 2009 from $10.4 million for the three monthsended March 31, 2008 primarily due to cash flows invested relating to theongoing construction of the North Dakota Bakken gathering system.

 

***CashFlows from Financing Activities***

 

Cash flows from financing activities increased to $7.9 million for thethree months ended March 31, 2009 from $0.5 million for the three monthsended March 31, 2008, an increase of $7.3 million. During the three monthsended March 31, 2009, Hiland Partners borrowed $12.0 million under itscredit facility to fund its internal expansion projects and made $0.2 millionpayments on capital lease obligations. During the three months ended March 31,2009, we made distributions of $2.2 million to our unitholders and HilandPartners distributed $1.8 million to the noncontrolling partners’ interestin Hiland Partners.

 

During the three months ended March 31, 2008, Hiland Partnersborrowed $9.0 million under its credit facility to fund its internal expansionprojects and received $0.6 million from issuing Hiland Partners common units asa result of the exercise of 22,039 vested unit options. During the threemonths ended March 31, 2008, Hiland Partners incurred debt issuance costsof $0.3 million associated with the fourth amendment to its credit facilityamended in February 2008 and made $0.1 million payments on capital lease obligations.During the three months ended March 31, 2008, we made a distribution of$5.5 million to our unitholders and Hiland Partners distributed$3.1 million to the noncontrolling partners’ interest in Hiland Partners.

 

***CapitalRequirements***

 

Hiland Partners’ midstream energy business is capital intensive,requiring significant investment to maintain and upgrade existing operations.Hiland Partners’ capital requirements have consisted primarily of, and weanticipate will continue to be:

 
| · | maintenance capital  expenditures, which are capital expenditures made to replace partially or  fully depreciated assets to maintain the existing operating capacity of  Hiland Partners’ assets and to extend their useful lives, or other capital  expenditures that are incurred in maintaining existing system volumes and  related cash flows; and |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                         |
| · | expansion  capital expenditures such as those to acquire additional assets to grow  Hiland Partners’ business, to expand and upgrade gathering systems,  processing plants, treating facilities and fractionation facilities and to  construct or acquire similar systems or facilities.                                                                |

 

We believe that cash generated from the operations of Hiland Partners’business will be sufficient to meet its anticipated maintenance capitalexpenditures for the next twelve months. Given Hiland Partners’ long-termobjective of growth through acquisitions and expansions, Hiland Partnersanticipates that it will continue to invest significant amounts of capital togrow and acquire assets. Hiland Partners actively considers a variety of assetsfor potential acquisitions. We anticipate that its expansion capital 

 

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expenditures willbe funded through long-term borrowings or other debt financings and/or equityofferings. See “Credit Facility” below for information related to our creditagreements.

 

***NorthDakota Bakken***

 

Hiland Partners’ North Dakota Bakken gathering system presentlyconsists of a 47-mile gathering system located in northwestern North Dakotathat will gather natural gas associated with crude oil produced from the Bakkenshale and Three Forks/Sanish formations. The gathering system, associatedcompression and treating facilities and a processing plant are currently underconstruction and are expected to become fully operational in the second quarterof 2009.  Construction of the processingplant and gathering system commenced in October 2008.  Portions of the processing plant andgathering system became operational in April 2009.  As of March 31, 2009, Hiland Partnershas invested approximately $18.9 million in the project.

 

***FinancialDerivatives and Commodity Hedges***

 

Hiland Partners has entered into certain financial derivativeinstruments that are classified as cash flow hedges in accordance with SFAS 133and relate to forecasted sales in 2009 and 2010. Hiland Partners entered intothese financial swap instruments to hedge the forecasted natural gas salesagainst the variability in expected future cash flows attributable to changesin commodity prices. Under these swap agreements, Hiland Partners receives afixed price and pays a floating price based on certain indices for the relevantcontract period as the underlying natural gas is sold.

 

The following table provides information about Hiland Partnerscommodity based derivative instruments at March 31, 2009:

 
| ** **                                           | ** ** | ** **  | ** ** | **Average**          | ** ** | ** **     | ** ** |
|------------------------------------------------------|------------|-------------|------------|----------------------|------------|----------------|------------|
| ** **                                           | ** ** | ** **  | ** ** | **Fixed**            | ** ** | **Fair Value** | ** ** |
| **Description and Production Period** | ** ** | **Volume**  | ** ** | **Price**            | ** ** | **Asset**      | ** ** |
|                                                 |       | **(MMBtu)** |       | **(per MMBtu)** |       |           |       |
| Natural Gas - Sold Fixed for Floating Price Swaps    |       |        |       |                 |       |           |       |
| April 2009 - March 2010                    |       | 2,136,000   |       | $                    | 7.55       |           | $          | 8,852 |   |
| April 2010 - December 2010                 |       | 1,602,000   |       | $                    | 8.31       |           | 5,869      |   |
|                                                 |       |        |       |                 |       | $              | 14,721     |   |

 

Hiland Partners has entered into a financial derivative instrument thatis classified as a cash flow hedge in accordance with SFAS 133 and relates toforecasted interest payments under its credit facility in 2009.  Hiland Partners entered into this financialswap instrument to hedge forecasted interest payments against the variable interestpayments under its credit facility. Under this contractual swap agreement, Hiland Partners pays a fixedinterest rate and receives a floating rate based on one month LIBOR on thenotional amount for the contract period. The following table providesinformation about Hiland Partners interest rate swap at March 31, 2009 forthe periods indicated:

 
| ** **                           | ** ** | ** **   | ** ** | ** **   | ** ** | **Fair Value**  | ** ** |
|--------------------------------------|------------|--------------|------------|--------------|------------|-----------------|------------|
| ** **                           | ** ** | **Notional** | ** ** | **Interest** | ** ** | **Asset**       | ** ** |
| **Description and Period**           | ** ** | **Amount**   | ** ** | **Rate**     | ** ** | **(Liability)** | ** ** |
| Interest Rate Swap                   |       |         |       |         |       |            |       |
| April 2009 - December 2009 |       | $            | 100,000    |         | 2.245      | %               | $          | (1,210 | ) |
|                                      |            |              |            |              |            |                 |            |  |  |

 

***Off-BalanceSheet Arrangements***

 

Neither we nor Hiland Partners had any significant off-balance sheetarrangements as of March 31, 2009.

 

***AvailableCredit***

 

Credit markets in the United States and around the world remainconstrained due to a lack of liquidity and confidence in a number of financialinstitutions. Investors continue to seek perceived safe investments insecurities of the United States government rather than corporate issues. HilandPartners may at times experience difficulty accessing the long-term creditmarkets due to prevailing market conditions. Additionally, existing constraintsin the credit markets may increase the rates Hiland Partners is charged forutilizing these markets.

 

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***CreditFacilities***

 

***HilandHoldings Credit Facility***

 

On September 25, 2006, concurrently with the closing of ourinitial public offering, Hiland Holdings entered into a three-year $25.0 millionsecured revolving credit facility.  The credit facility will permit us, ifcertain conditions are met, to increase borrowing capacity by up to anadditional $25.0 million. The credit facility is secured by all of ourownership interests in Hiland Partners and its general partner, other than the2% general partner interest and the incentive distribution rights.

 

The credit facility will mature on September 25, 2009, at whichtime all outstanding amounts thereunder become due and payable.

 

Indebtedness under the credit facility will bear interest, at ouroption, at either: (i) an Alternate Base Rate plus an applicable marginranging from 100 to 150 basis points per annum or (ii) LIBOR plus anapplicable margin ranging from 200 to 250 basis points per annum in each casebased on our ratio of consolidated funded debt to EBITDA. The Alternate BaseRate is equal to the greatest of: (a) the prime rate in effect on suchday, (b) the base CD rate in effect on such day plus 1.50% and (c) thefederal funds effective rate in effect on such day plus 1/2 of 1%. We haveelected for the indebtedness to bear interest at LIBOR plus the applicablemargin. A letter of credit fee will be payable for the aggregate amount ofletters of credit issued under the credit facility at a percentage per annumequal to 2.0%. A commitment fee ranging from 25 to 50 basis points per annumbased on our ratio of consolidated funded debt to EBITDA will be payable on theaverage daily unused portion of the credit facility for the quarter mostrecently ended. At March 31, 2009, the interest rate on outstandingborrowings from our credit facility was 2.55%.

 

The credit facility contains several covenants that, among otherthings, require the maintenance of two financial performance ratios, restrictthe payment of distributions to unitholders, and require financial reports tobe submitted periodically to the financial institutions.

 

The credit facility also contains covenants requiring a maximumconsolidated 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 borrow under the credit facility is limited to thelesser of: (i) 50% of the sum of the value of the Hiland Partners commonand subordinated units and certain other assets held by us and certain of oursubsidiaries at the end of each fiscal quarter and (ii) the maximumavailable amount of the credit facility (currently $25.0 million). For purposesof this calculation, the value of (i) the Hiland Partners common units onany date shall be the closing price for such units as reflected on the NASDAQNational Market on any date and (ii) the Hiland Partners subordinatedunits on any date shall be deemed to equal 85% of the value of the Hiland Partnerscommon units on such date. At March 31, 2009, the borrowing base was $19.8million.

 

The credit facility prohibits us from making distributions tounitholders if any default or event of default, as defined in the creditfacility, has occurred and is continuing or would result from suchdistributions. In addition, the credit facility contains various covenants thatlimit, among other things, subject to certain exceptions and negotiated “baskets,”our ability to incur indebtedness, grant liens, enter into agreementsrestricting our ability to grant liens on our assets or amend the creditfacility, make certain loans, acquisitions and investments or enter into amerger, consolidation or sale of assets.

 

The credit facility limits distributions to our unitholders to ouravailable cash, as defined in our partnership agreement. Restricted paymentsunder the credit facility are subject to an annual “clean-down” period of 15consecutive days in which the amount outstanding that relates to funding therestricted payments under the credit facility must be reduced to zero.

 

As of March 31, 2009, we had $0.7 million outstanding underthis credit facility and were in compliance with our financial covenants. Theoutstanding $0.7 million, which matures on September 25, 2009, isincluded in accrued liabilities and other in the balance sheet.

 

***Hiland Partners Credit Facility***

 

Hiland Partners borrowing capacity under its senior secured revolvingcredit facility, as amended, is $300 million consisting of a $291 million seniorsecured revolving credit facility to be used for funding acquisitions and othercapital expenditures, issuance of letters of credit and general corporatepurposes (the “Acquisition Facility”) and a $9.0 million senior securedrevolving credit facility to be used for working capital and to funddistributions (the “Working Capital Facility”).

 

In addition, Hiland Partners’ senior secured revolving credit facilityprovides for an accordion feature, which permits Hiland Partners, if certainconditions are met, to increase the size of the Acquisition Facility by up to$50 million and allows for the issuance of letters of credit of up to$15 million in the aggregate. The senior secured revolving credit facilityalso requires Hiland Partners to meet certain financial tests, including amaximum consolidated funded debt to EBITDA ratio of 4.0:1.0 as of the last dayof any fiscal quarter; provided that in the event that Hiland Partners makescertain permitted acquisitions or capital expenditures, this ratio may beincreased to 4.75:1.0 for the three fiscal quarters following the quarter inwhich such acquisition or capital expenditure occurs; and a 

 

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minimum interestcoverage ratio of 3.0:1.0.  The creditfacility will mature in May 2011. At that time, the agreement willterminate and all outstanding amounts thereunder will be due and payable.

 

Due to the recent decline in natural gas and NGL prices, HilandPartners believes that its cash generated from operations will decrease for theremainder of 2009 relative to comparable periods in 2008. Hiland Partners’senior secured revolving credit facility requires it to meet certain financialtests, including a maximum consolidated funded debt to EBITDA covenant ratio of4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscalquarters following the quarter in which such acquisition or capital expenditureoccurs. Hiland Partners met the permitted capital expenditure requirements forthe four quarter period ended March 31, 2009 and elected to increase theratio to 4.75:1.0 on March 31, 2009. During this step-up period, theapplicable margin with respect to loans under the credit facility increases by35 basis points per annum and the unused commitment fee increases by 12.5 basispoints per annum. Unless this ratio is amended, Hiland Partners’ debt isrestructured or Hiland Partners receives an infusion of equity capital,management expects that Hiland Partners will be in violation of the maximumfunded debt to EBITDA covenant ratio contained in its senior secured revolvingcredit facility as early as the second quarter of 2009.  Management has initiated discussions withcertain lenders under Hiland Partners’ credit facility as to potential ways toaddress the expected covenant violation. While no potential solution has beenagreed to, Hiland Partners would expect that any solution would likely requirethe assessment of fees and increased rates, the infusion of additional equitycapital or the incurrence of subordinated indebtedness by Hiland Partners, andthe suspension of distributions for a certain period of time. There can be noassurance that any such agreement will be reached with the lenders or that anyrequired equity or debt financing will be available to Hiland Partners.

 

Upon the occurrence of an event of default defined in the creditfacility, the lenders may, among other things, be able to accelerate thematurity of the credit facility and exercise other rights and remedies as setforth in the credit facility.

 

Hiland Partners’ obligations under the credit facility are secured bysubstantially all of its assets and guaranteed by Hiland Partners and all ofits subsidiaries, other than Hiland Operating, LLC, its operating company,which is the borrower under the credit facility.

 

Indebtedness under the credit facility will bear interest, at HilandPartners’ option, at either; (i) an Alternate Base Rate plus an applicablemargin ranging from 50 to 125 basis points per annum or (ii) LIBOR plus anapplicable margin ranging from 150 to 225 basis points per annum based onHiland Partners’ ratio of consolidated funded debt to EBITDA. The AlternateBase Rate is a rate per annum equal to the greatest of (a) the Prime Ratein effect on such day, (b) the base CD rate in effect on such day plus1.50% and (c) the Federal Funds effective rate in effect on such day plus1⁄2 of 1%. Hiland Partners has elected for the indebtedness to bear interest atLIBOR plus the applicable margin.  Aletter of credit fee will be payable for the aggregate amount of letters ofcredit issued under the credit facility at a percentage per annum equal to1.0%. An unused commitment fee ranging from 25 to 50 basis points per annumbased on Hiland Partners’ ratio of consolidated funded debt to EBITDA will bepayable on the unused portion of the credit facility. During the step-upperiod, the applicable margin with respect to loans under the credit facilitywill be increased by 35 basis points per annum and the unused commitment feewill be increased by 12.5 basis points per annum.  At March 31, 2009, the interest rate onoutstanding borrowings from Hiland Partners’ credit facility was 3.15%.

 

Hiland Partners is subject to interest rate risk on its credit facilityand has entered into an interest rate swap to reduce this risk. See Note 5“Derivatives” for a discussion of Hiland Partners’ interest rate swap.

 

The credit facility prohibits Hiland Partners from making distributionsto unitholders if any default or event of default, as defined in the creditfacility, has occurred and is continuing or would result from suchdistributions. In addition, the credit facility contains various covenants thatlimit, among other things, subject to certain exceptions and negotiated “baskets,”Hiland Partners’ ability to incur indebtedness, grant liens, make certainloans, acquisitions and investments, make any material changes to the nature ofits business, amend its material agreements, including the Omnibus Agreement orenter into a merger, consolidation or sale of assets.

 

The credit facility defines EBITDA as Hiland Partners’ consolidated netincome (loss), plus income tax expense, interest expense, depreciation,amortization and accretion expense, amortization of intangibles andorganizational costs, non-cash unit based compensation expense, and adjustmentsfor non-cash gains and losses on specified derivative transactions and forother extraordinary items.

 

The credit facility limits distributions to Hiland Partners’unitholders to available cash, as defined by the agreement, and borrowings tofund such distributions are only permitted under the revolving working capitalfacility. The revolving working capital facility is subject to an annual “clean-down”period of 15 consecutive days in which the amount outstanding under the revolvingworking capital facility is reduced to zero.

 

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As of March 31, 2009, Hiland Partners had $264.1 million outstandingunder the credit facility and 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.

 

***Recent Accounting Pronouncements***

 

On April 1, 2009, the Financial Accounting Standards Board (“FASB”)issued Staff Position No. FAS 141(R)-1, “Accounting for Assets Acquiredand Liabilities Assumed in a Business Combination That Arise from Contingencies”(“FSP141(R)-1”).  FSP 141(R)-1 amends andclarifies SFAS 141, revised 2007, “Business Combinations” to addressapplication issues on initial and subsequent recognition, measurement,accounting and disclosure of assets and liabilities arising from contingenciesin a business combination.  FSP 141(R)-1is effective for assets and liabilities arising from contingencies in businesscombinations for which the acquisition date is on or after the first annualreporting period beginning on or after December 15, 2008. FSP 141(R)-1 wasadopted effective January 1, 2009 and did not have a material impact onour financial statements and disclosures therein.

 

On April 25, 2008, the FASB issued Staff Position No. FAS142-3, “Determination of the Useful Lifeof Intangible Assets” (“FSP 142-3”). FSP 142-3 amends the factors that an entity should consider indeveloping renewal or extension assumptions used in determining the useful lifeof recognized intangible assets under FASB Statement No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets”.In determining the useful life of an acquired intangible asset, FSP 142-3removes the requirement from SFAS 142 for an entity to consider whether renewalof the intangible asset requires significant costs or material modifications tothe related arrangement. FSP 142-3 also replaces the previous useful lifeassessment criteria with a requirement that an entity considers its ownexperience in renewing similar arrangements. If the entity has no relevantexperience, it would consider market participant assumptions regardingrenewal.  FSP 142-3 was adopted effective January 1, 2009 and willapply to future business combinations.

 

On March 19, 2008, the FASB issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities”, an amendment of SFAS 133(“SFAS 161”). SFAS 161 is intended to improve transparency in financialreporting by requiring enhanced disclosures of an entity’s derivativeinstruments and hedging activities and their effects on the entity’s financialposition, financial performance, and cash flows. SFAS 161 is effectiveprospectively for financial statements issued for fiscal years and interimperiods beginning after November 15, 2008, with early applicationencouraged. SFAS 161 encourages, but does not require, comparative disclosuresfor periods prior to its initial adoption. SFAS 161 amended the qualitative andquantitative disclosure requirements for derivative instruments and hedgingactivities set forth in SFAS 133 and generally increased the level ofaggregation/disaggregation required in an entity’s financial statements. SFAS161 was adopted effective January 1, 2009 and did not have a materialimpact on our financial statements and disclosures therein.

 

On March 12, 2008, the Emerging Issues Task Force (“EITF”) reachedconsensus opinion on EITF Issue 07-4, “Application of the two-class methodunder FASB Statement No. 128, Earnings per Share, to Master LimitedPartnerships” (“EITF 07-4”), which the FASB ratified at its March 26, 2008meeting.  EITF 07-4 requires thecalculation of a Master Limited Partnership’s (“MLPs”) net earnings per limitedpartner unit for each period presented according to distributions declared andparticipation rights in undistributed earnings as if all of the earnings forthat period had been distributed. In periods with undistributed earnings abovespecified levels, the calculation per the two-class method results in anincreased allocation of such undistributed earnings to the general partner anda dilution of earnings to the limited partners. EITF 07-4 is effective for fiscal years beginning after December 15,2008, and is to be applied retrospectively to all periods presented.  EITF 07-4 was adopted effective January 1,2009 and did not have a significant impact on our financial statements anddisclosures therein.

 

In December 2007, the FASB issued SFAS No. 141(R), “BusinessCombinations” (“SFAS 141(R)”). SFAS 141(R) amends and replaces SFAS 141,but retains the fundamental requirements in SFAS 141 that the purchase methodof accounting be used for all business combinations and an acquirer beidentified for each business combination. SFAS 141(R) provides for how theacquirer recognizes and measures the identifiable assets acquired, liabilitiesassumed and any noncontrolling interest in the acquiree. SFAS 141(R) providesfor how the acquirer recognizes and measures the goodwill acquired in thebusiness combination or a gain from a bargain purchase. SFAS 141(R) alsodetermines what information to disclose to enable users to be able to evaluatethe nature and financial effects of the business combination. The provisions ofSFAS 141(R) apply prospectively to business combinations for whichthe acquisition date is on or after the beginning of the first annual reportingperiod beginning on or after December 15, 2008. SFAS 141(R) wasadopted effective January 1, 2009 and will apply to future businesscombinations.

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS159 expands opportunities to use fair value measurement in financial reportingand permits entities to choose to measure many financial instruments andcertain other items at fair value. SFAS 159 is effective for fiscal yearsbeginning after 

 

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November 15,2007. SFAS 159 was adopted effective January 1, 2008, at which time nofinancial assets or liabilities, not previously required to be recorded at fairvalue by other authoritative literature, were designated to be recorded at fairvalue.  As such, the adoption of SFAS 159did not have any impact on our financial position, results of operations orcash flows.

 

In September 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (“SFAS 157”).  SFAS 157defines fair value as the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date, establishes a framework for measuring fair value ingenerally accepted accounting principles (“GAAP”) such as fair value hierarchyused to classify the source of information used in fair value measurements(i.e., market based or non-market based) and expands disclosure about fairvalue measurements based on their level in the hierarchy.  SFAS 157 applies to derivatives and otherfinancial instruments, which SFAS 133 requires be measured at fair value atinitial recognition and for all subsequent periods. SFAS 157 establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.SFAS 157’s hierarchy defines three levels of inputs that may be used to measurefair value. Level 1 refers to assets that have observable market prices, level2 assets do not have an “observable price” but do have inputs that are based onsuch prices in which components have observable data points and level 3 refersto assets in which one or more of the inputs do not have observable prices andcalibrated model parameters, valuation techniques or management’s assumptionsare used to derive the fair value. SFAS 157 is effective for financialstatements issued for fiscal years beginning after November 15, 2007 andinterim periods within those fiscal years. We elected to implement SFAS 157prospectively in the first quarter of 2008 with the one-year deferral permittedby FASB Staff Position (FSP) 157-2 for nonfinancial assets andnonfinancial liabilities measured at fair value, except those that arerecognized or disclosed on a recurring basis (at least annually). The deferralapplies to nonfinancial assets and liabilities measured at fair value in abusiness combination; impaired properties, plants and equipment; intangibleassets and goodwill; and initial recognition of asset retirement obligationsand restructuring costs for which we use fair value. SFAS 157 was adoptedeffective January 1, 2009 and did not have a material impact on ourfinancial statements.

 

In December 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51”(“SFAS 160”). SFAS 160 establishes accounting and reporting standards thatrequire the ownership interests in subsidiaries held by parties other than theparent (minority interest) be clearly identified, labeled and presented in theconsolidated balance sheet within equity, but separate from the parent’sequity. SFAS 160 requires the equity amount of consolidated net incomeattributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated income statement andthat changes in a parent’s ownership interest while the parent retains itscontrolling financial interest in its subsidiary be accounted for consistentlyand similarly as equity transactions. Consolidated net income and comprehensiveincome are now determined without deducting minority interest; however,earnings-per-share information continues to be calculated on the basis of thenet income attributable to the parent’s shareholders.  Additionally, SFAS 160 establishes a singlemethod for accounting for changes in a parent’s ownership interest in asubsidiary that does not result in deconsolidation and that the parentrecognize a gain or loss in net income when a subsidiary isdeconsolidated.  SFAS 160 is effectivefor fiscal years beginning on or after December 15, 2008. SFAS 160 wasadopted effective January 1, 2009 and did not have a material impact onour financial position, results of operations or cash flows.

 

Certain adjustments have been made to prior period information toconform to current period presentation related to our adoption of SFAS 160,which establishes new accounting and reporting standards for the noncontrollingpartners’ interest in Hiland Partners.  Specifically, SFAS 160 requiresthe recognition of a noncontrolling interest (minority interests) as equity inthe consolidated financial statements and separate from our limited partners’equity.  The amount of net income attributable to the noncontrollinginterest will now be included in consolidated net income on the face of thestatement of operations.  SFAS 160 also includes expanded disclosurerequirements regarding our limited partners’ interest and the noncontrollingpartners’ interest.  The adoption of SFAS 160 on January 1, 2009 didnot have a significant impact on our financial position, results of operationsor cash flows.  However, it did result in certain changes to our financialstatement presentation, including the change in classification ofnoncontrolling interest (minority interests) from liabilities to equity on theconsolidated balance sheet.

 

Upon adoption of SFAS 160 effective January 1, 2009, wereclassified $125,851 from minority interests liabilities to noncontrollingpartners’ interest in Hiland Partners, of which $123,729 is a separatecomponent of equity and $2,122 is an increase to accumulated othercomprehensive income, also a component of equity, in our consolidated balancesheet as of December 31, 2008.  In addition, we reclassified $209 ofminority interest in loss of Hiland Partners to net loss attributable tononcontrolling partners’ interest in loss of Hiland Partners in ourconsolidated statement of operations for the three months ended March 31,2008.  Net income per limited partner unit has not been affected as aresult of the adoption of SFAS 160.

 

***SignificantAccounting Policies and Estimates***

 

The selection and application ofaccounting policies is an important process that has developed as our businessactivities have evolved and as the accounting rules have developed. Accounting rules generally do not involve a selection among alternatives, butinvolve the implementation and interpretation of existing rules, and the use ofjudgment applied to the specific set of circumstances existing in ourbusiness.  We make every effort to properly comply with all applicablerules on or before their adoption, and we believe the proper implementation andconsistent application of the accounting rules are critical. 

 

There have been no material changes in oursignificant accounting policies and estimates during the three months endedMarch 31, 2009.  See our disclosureof significant accounting policies and estimates in Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” onour Annual Report on Form 10-K for the year ended December 31, 2008, filedwith the SEC on March 9, 2009.

 

**Item3.  Quantitative and QualitativeDisclosures about Market Risk**

 

Market risk is the risk of loss arising from adverse changes in marketrates and prices. The principal market risk to which Hiland Partners is exposedis commodity price risk for natural gas and NGLs. Hiland Partners also incurs,to a lesser extent, risks related to interest rate fluctuations. HilandPartners does not engage in commodity energy trading activities.

 

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***Commodity Price Risks.  *** Hiland Partners’ profitability is affected byvolatility in prevailing NGL and natural gas prices. Historically, changes inthe prices of most NGL products have generally correlated with changes in theprice of crude oil. NGL and natural gas prices are volatile and are impacted bychanges in the supply and demand for NGLs and natural gas, as well as marketuncertainty. Hiland Partners’ cash flow is affected by the volatility ofnatural gas and NGL product prices, which could adversely affect our ability tomake distributions to unitholders. To illustrate the impact of changes inprices for natural gas and NGLs on our operating results, we have provided thetable below, which reflects, for the three months ended March 31, 2009 andMarch 31, 2008, respectively, the impact on our midstream segment marginof a $0.01 per gallon change (increase or decrease) in NGL prices coupled witha $0.10 per MMBtu change (increase or decrease) in the price of natural gas.

 
| ** **                   | ** ** | **Natural Gas Price Change ($/MMBtu)  Three Months Ended March 31,** | ** ** |
|------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                   | ** ** | **2009**                                                                  | ** ** | **2008** | ** ** |
| ** **                   | ** ** | **$0.10**                                                                 | ** ** | **$(0.10)** | ** ** | **$0.10** | ** ** | **$(0.10)** | ** ** |
| **NGL Price Change ($/gal)** |       |                                                                      |       |   |   |   |   |   |   |
| $0.01                        |       | $                                                                         | 173,000    |   | $ | 186,000 |   | $ | 144,000 |   | $ | 113,000 |   |
| $(0.01)                      |       | $                                                                         | (125,000   | ) | $ | (172,000 | ) | $ | (112,000 | ) | $ | (144,000 | ) |

 

The increase in commodity exposure is the result of increased naturalgas and NGL product volumes during the three months ended March 31, 2009compared to the three months ended March 31, 2008 and the increasedexposure to NGL product prices in 2009 as the result of no NGL hedgingcontracts in 2009. The magnitude of the impact on total segment margin ofchanges in natural gas and NGL prices presented may not be representative ofthe magnitude of the impact on total segment margin for different commodityprices or contract portfolios. Natural gas and crude oil prices can also affectour profitability indirectly by influencing the level of drilling activity andrelated opportunities for our services.

 

We manage this commodity price exposure through an integrated strategythat includes management of our contract portfolio, optimization of our assetsand the use of derivative contracts. As a result of these derivative swapcontracts, we have hedged a portion of our expected exposure to natural gasprices in 2009 and 2010. We continually monitor our hedging and contractportfolio and expect to continue to adjust our hedge position as conditionswarrant. The following table provides information about our commodity-basedderivative instruments at March 31, 2009 for the periods indicated:

 
| ** **                                           | ** ** | ** **  | ** ** | **Average**          | ** ** | ** **     | ** ** |
|------------------------------------------------------|------------|-------------|------------|----------------------|------------|----------------|------------|
| ** **                                           | ** ** | ** **  | ** ** | **Fixed**            | ** ** | **Fair Value** | ** ** |
| **Description and Production Period** | ** ** | **Volume**  | ** ** | **Price**            | ** ** | **Asset**      | ** ** |
|                                                 |       | **(MMBtu)** |       | **(per MMBtu)** |       |           |       |
| Natural Gas - Sold Fixed for Floating Price Swaps    |       |        |       |                 |       |           |       |
| April 2009 - March 2010                    |       | 2,136,000   |       | $                    | 7.55       |           | $          | 8,852 |   |
| April 2010 - December 2010                 |       | 1,602,000   |       | $                    | 8.31       |           | 5,869      |   |
|                                                 |       |        |       |                 |       | $              | 14,721     |   |

 

***Interest Rate Risk.***   We have elected for the indebtedness tobear interest at LIBOR plus the applicable margin. We are exposed to changes inthe LIBOR rate as a result of our credit facility and Hiland Partners’ creditfacility, which is subject to floating interest rates.  On October 7,2008, Hiland Partners entered into a floating-to-fixedinterest rate swap agreement with an investment grade counterpartywhereby Hiland Partners pays a monthly fixed interest rate of 2.245% andreceives a monthly variable rate based on the one month posted LIBOR interestrate on a notional amount of $100.0 million. This swap agreement was effective on January 2, 2009 and terminateson January 1, 2010.  As of March 31,2009, Hiland Partners had approximately $264.1 million of indebtednessoutstanding under its credit facility, of which $164.1 million is exposed to changesin the LIBOR rate. The impact of a 100 basis point increase in interest rateson the amount of current debt exposed to variable interest rates would for theremainder of 2009, result in an increase in annualized interest expense and acorresponding decrease in annualized net income of approximately $1.2 million. The followingtable provides information about Hiland Partners’ interest rate swap at March 31,2009 for the periods indicated:

 
| ** **                           | ** ** | ** **   | ** ** | ** **   | ** ** | **Fair Value**  | ** ** |
|--------------------------------------|------------|--------------|------------|--------------|------------|-----------------|------------|
| ** **                           | ** ** | **Notional** | ** ** | **Interest** | ** ** | **Asset**       | ** ** |
| **Description and Period**           | ** ** | **Amount**   | ** ** | **Rate**     | ** ** | **(Liability)** | ** ** |
| Interest Rate Swap                   |       |         |       |         |       |            |       |
| April 2009 - December 2009 |       | $            | 100,000    |         | 2.245      | %               | $          | (1,210 | ) |
|                                      |            |              |            |              |            |                 |            |  |  |

 

***Credit Risk.****  *Counterparties pursuant to the terms of their contractual obligations exposeHiland Partners to potential losses as a result of nonperformance. HilandPartners’ three largest customers for the three months ended March 31,2009 accounting for approximately 19%, 17% and 12%, respectively, of revenues.Consequently, changes within one or more of these companies’ operations havethe potential to impact, both positively and negatively, our credit exposureand make us subject to risks of loss resulting from nonpayment ornonperformance by these or any of Hiland Partners’ other customers. Anymaterial nonpayment or 

 

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nonperformance byits key customers could materially and adversely affect our business, financialcondition or results of operations and reduce Hiland Partners’ ability to makedistributions to its unitholders. Furthermore, some of Hiland Partners’customers may be highly leveraged and subject to their own operating andregulatory risks, which increases the risk that they may default on theirobligations to Hiland Partners.  HilandPartners’ counterparties for Hiland Partners’ derivative instruments as of March 31,2009 are BP Energy Company and Bank of Oklahoma, N.A. Our counterparty to our interest rateswap as of March 31, 2009 is Wells Fargo Bank, N.A.

 

On July 22, 2008,SemGroup, L.P. and certain subsidiaries filed voluntary petitions forreorganization under Chapter 11 of the U.S. Bankruptcy Code.  In October 2008, the United StatesBankruptcy Court for the District of Delaware entered an order approving theassumption of a Natural Gas Liquids Marketing Agreement (the “SemStreamAgreement”) between SemStream, L.P., an affiliate of SemGroup, L.P., and HilandPartners relating to the sale of natural gas liquids and condensate at ourBakken and Badlands plants and gathering systems, restoring Hiland Partners andSemStream, L.P. to its pre-bankruptcy contractual relationship.  Hiland Partners pre-petition credit exposureto SemGroup, L.P. relating to condensate sales to SemCrude, LLC in ourmid-continent region is approximately $0.3 million, which continues to bereserved as of March 31, 2009.

 

**Item 4. Controls and Procedures**

 

**Evaluation of Disclosure Controls and Procedures**

 

(a)          Evaluation of disclosure controls andprocedures.

 

Asrequired by Rule 13a-15(b) under the Securities Exchange Act of 1934,as amended, we have evaluated, under the supervision and with the participationof our management, including our principal executive officer and principalfinancial officer, the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act) as of the end of the period covered bythis Quarterly Report on Form 10-Q. Based upon that evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures were effective as of March 31, 2009, toensure that information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure and isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the SEC.

 

(b)         Changes in internal control overfinancial reporting.

 

Duringthe three months ended March 31, 2009, there were no changes in our systemof internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**PART II OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

Two unitholderclass action lawsuits were recently filed in the Court of Chancery of the Stateof Delaware challenging the proposal made by Mr. Hamm to acquire all ofthe outstanding common units of each of the Partnership and Hiland Partnersthat are not owned by Mr. Hamm, his affiliates or Hamm family trusts.

 

On May 1, 2009, a unitholder of the Partnershipand Hiland Partners filed a complaint alleging claims on behalf of (i) apurported class of common unitholders of the Partnership and (ii) apurported class of common unitholders of Hiland Partners against thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and the members of the board of directors of each of thePartnership and Hiland Partners. The complaint alleges, among other things,that the original consideration and revised consideration offered by Mr. Hammis unfair and inadequate, that the board of directors of the general partner ofeach of the Partnership and Hiland Partners cannot be expected to actindependently, and that Mr. Hamm and the management of the Partnership andHiland Partners have manipulated their public statements to depress the priceof the common units of the Partnership and Hiland Partners. The plaintiffs seekto enjoin the Partnership, Hiland Partners, and their respective board membersfrom proceeding with any transaction that may arise from Mr. Hamm’s goingprivate proposal, along with compensatory damages.

 

On February 26, 2009, a unitholder of the Partnership and HilandPartners filed a complaint alleging claims on behalf of a purported class ofcommon unitholders of the Partnership and Hiland Partners against thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and certain members of the board of directors of each ofthe Partnership and Hiland Partners The complaint alleges, among other things,that the consideration offered is unfair and grossly inadequate, that theconflicts committee of the board of directors of the general partner of each ofthe Partnership and Hiland Partners cannot be expected to act independently,and that the management of the Partnership and Hiland Partners has manipulatedits public statements to depress the price of the common units of thePartnership and Hiland Partners.

 

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The plaintiffs in each lawsuit seek to enjoin the Partnership, HilandPartners, and their respective board members from proceeding with anytransaction that may arise from Mr. Hamm’s going private proposal, alongwith compensatory damages. We cannot predict the outcome of these lawsuits, orothers, nor can we predict the amount of time and expense that will be requiredto resolve the lawsuits.

 

We are not aware of any legal or governmental proceedings against us,or contemplated to be brought against us, under the various environmentalprotection statutes to which we are subject. We maintain insurance policieswith insurers in amounts and with coverage and deductibles as our generalpartner believes are reasonable and prudent. However, we cannot assure you thatthis insurance will be adequate to protect us from all material expensesrelated to potential future claims for personal and property damage or thatthese levels of insurance will be available in the future at economical prices.

 

**Item 1A. Risk Factors**

 

***Asubstantial portion of our partnership interests in Hiland Partners aresubordinated to Hiland Partners’ common units, which will result in decreaseddistributions to us in the future  untilHiland Partners has paid all distribution arrearages on the Hiland Partnerscommon units.   Additionally, if HilandPartners is unable to meet its minimum quarterly distribution in the future,distributions to us could further decrease.***

 

We own, directly or indirectly, 5,381,471 units representing limitedpartner interests in Hiland Partners, of which approximately 56.9% aresubordinated units and 43.1% are common units. During the subordination period,the subordinated units will not receive any distributions in a quarter untilHiland Partners has paid the minimum quarterly distribution of $0.45 per unit,plus any arrearages in the payment of the minimum quarterly distribution fromprior quarters, on all of the outstanding Hiland Partners common units.Distributions on the subordinated units are therefore more uncertain thandistributions on Hiland Partners’ common units. Furthermore, no distributionsmay be made on the incentive distribution rights for any quarter unless HilandPartners has paid that quarter’s minimum quarterly distribution of $0.45 perunit for all outstanding Hiland Partners common units and subordinated units,plus any arrearages in the payment of the minimum quarterly distribution fromprior quarters on all the outstanding Hiland Partners common units. Therefore,distributions with respect to the incentive distribution rights are even moreuncertain than distributions on the subordinated units. Neither thesubordinated units nor the incentive distribution rights are entitled to anyarrearages from prior quarters. Generally, the subordination period ends, andthe subordinated units convert into common units of Hiland Partners, only afterMarch 31, 2010 and only upon the satisfaction of certain financial tests.

 

On April 27, 2009, Hiland Partners announced the suspension ofquarterly cash distributions on its common and subordinated units beginningwith the first quarter of 2009.  Underthe terms of the Hiland Partners partnership agreement, the Hiland Partnerscommon units now carry an arrearage of $0.45 per unit, representing the minimumquarterly distribution to the Hiland Partners common units for the firstquarter of 2009 that must be paid before Hiland Partners can make distributionsto the Hiland Partners subordinated units or on the incentive distributionrights.  This decrease in distributionsto us could adversely affect our ability to pay distributions on our commonunits.

 

In addition to the other information set forth in this report, youshould carefully consider the factors discussed in Part I, Item 1A. “RiskFactors” in our Annual Report on Form 10-K for the year ended December 31,2008, which could materially affect our business, financial condition or futureresults. The risks described in our Annual Report on Form 10-K are not theonly risks facing the Partnership. Additional risks and uncertainties notcurrently known to us or that we currently deem to be immaterial also maymaterially adversely affect our business, financial condition and/ or operatingresults.

 

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

 

None.

 

**Item 3.Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5.Other Information**

 

On January 27, 2009, we received a Deficiency Letter from NASDAQindicating that we no longer comply with the audit committee compositionrequirements as set forth in Marketplace Rule 4350(d), which requiresHiland Partners GP Holdings, LLC, our general partner, to have an auditcommittee of at least three independent members.  Following the resignation of Shelby E. Odellfrom 

 

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the board ofdirectors of our general partner on January 21, 2009, the audit committeeof our general partner consists of only two independent members.  Mr. Odell resigned from the board ofdirectors of our general partner so that he would be eligible to serve as amember of the conflicts committee of the board of directors of Hiland Partners’general partner.  In accordance withMarketplace Rule 4350(d)(4), NASDAQ has provided us a cure period toregain compliance until the earlier of our next annual unitholders’ meeting or January 21,2010, or, if the next annual unitholders’ meeting is held before July 20,2009, then we must evidence compliance no later than July 20, 2009.

 

**Item 6. Exhibits**

 

**EXHIBITS**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 1.1                     |       | Underwriting Agreement  by and between Hiland Holdings GP, LP and Lehman Brothers Inc., as  representative of the underwriters named therein dated as of  September 19, 2006. (incorporated by reference to Exhibit 1.1 of  Registrant’s Statement on Form S-1 (File No. 333-134491))                                                                                                                                                                                                               |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.1                     |       | Contribution  Agreement among Hiland Holdings GP, LP, Hiland Partners GP  Holdings, LLC, Hiland Partners GP, Inc., Continental Gas  Holdings, Inc., HHGP Holding, LLC, Harold Hamm DST Trust, Harold  Hamm HJ Trust, Randy Moeder, Equity Financial Services, Inc. and Ken  Maples dated May 24, 2006. (incorporated by reference to  Exhibit 2.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                       |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.2                     |       | Acquisition  Agreement by and among Hiland Operating, LLC, Hiland Partners, LLC and the  members of Hiland Partners, LLC dated as of September 1, 2005  (incorporated by reference to Exhibit 2.2 of Hiland Partners, LP’s  Form 8-K filed on September 29, 2005)                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.3                     |       | Amendment  No. 1 dated September 12, 2006 to Contribution Agreement among  Hiland Holdings GP, LP, Hiland Partners GP Holdings, LLC, Hiland  Partners GP, Inc., Continental Gas Holdings, Inc., HHGP  Holding, LLC, Harold Hamm DST Trust, Harold Hamm HJ Trust, Randy Moeder,  Equity Financial Services, Inc. and Ken Maples dated May 24, 2006.  (incorporated by reference to Exhibit 2.3 of Registrant’s Statement on  Form S-1 (File No. 333-134491)) |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.1                     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.2                     |       | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.1 of Registrant’s Form 10-Q  filed on November 13, 2006)                                                                                                                                                                                                                                                                                                                       |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.3                     |       | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.4                     |       | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006)                                                                                                                                                                                                                                                                                                      |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1                     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.2                     |       | Amended and Restated  Agreement of Limited Partnership of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 3.1 of Registrant’s Form 10-Q filed on  November 13, 2006)                                                                                                                                                                                                                                                                                                                       |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.3                     |       | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.4                     |       | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006)                                                                                                                                                                                                                                                                                                      |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1                    |       | Compensation of  Conflicts Committee Members                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 19.1                    |       | Code of Ethics  for Chief Executive Officer and Senior Finance Officers (incorporated by  reference to Exhibit 19.1 of Registrant’s annual report on Form 10-K filed on  March 20, 2007)                                                                                                                                                                                                                                                                                                                                |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 21.1                    |       | List of  Subsidiaries of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 21.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                                |

 

48

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Table of Contents

 
| 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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*+*Denotes a management contract orcompensatory plan or arrangement.

*†*Portions of this exhibit have beenomitted pursuant to a request for confidential treatment.

 

49

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Table ofContents

 

**SIG**N**ATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized in Enid,Oklahoma, on this 11th day of May, 2009.

 
|            | **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**(principal executive officer)* |
|       |                        |   |
|       |                        |   |
|       | By:                         | /s/ Matthew S. Harrison |
|       |                        | Matthew S. Harrison |
| * *   | * *                    | *Chief  Financial Officer, Vice President-Finance, Secretary and Director**(principal financial and accounting officer)* |

 

50

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Table ofContents

 

**Exhibit Index**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **              | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 1.1                     |       | Underwriting  Agreement by and between Hiland Holdings GP, LP and Lehman Brothers Inc., as  representative of the underwriters named therein dated as of  September 19, 2006. (incorporated by reference to Exhibit 1.1 of  Registrant’s Statement on Form S-1 (File No. 333-134491))                                                                                                                                                                                                               |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.1                     |       | Contribution  Agreement among Hiland Holdings GP, LP, Hiland Partners GP  Holdings, LLC, Hiland Partners GP, Inc., Continental Gas  Holdings, Inc., HHGP Holding, LLC, Harold Hamm DST Trust, Harold  Hamm HJ Trust, Randy Moeder, Equity Financial Services, Inc. and Ken  Maples dated May 24, 2006. (incorporated by reference to Exhibit 2.1  of Registrant’s Statement on Form S-1 (File No. 333-134491))                                                        |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.2                     |       | Acquisition  Agreement by and among Hiland Operating, LLC, Hiland Partners, LLC and the  members of Hiland Partners, LLC dated as of September 1, 2005  (incorporated by reference to Exhibit 2.2 of Hiland Partners, LP’s  Form 8-K filed on September 29, 2005)                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.3                     |       | Amendment  No. 1 dated September 12, 2006 to Contribution Agreement among  Hiland Holdings GP, LP, Hiland Partners GP Holdings, LLC, Hiland  Partners GP, Inc., Continental Gas Holdings, Inc., HHGP  Holding, LLC, Harold Hamm DST Trust, Harold Hamm HJ Trust, Randy Moeder,  Equity Financial Services, Inc. and Ken Maples dated May 24, 2006.  (incorporated by reference to Exhibit 2.3 of Registrant’s Statement on  Form S-1 (File No. 333-134491)) |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.1                     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.2                     |       | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.1 of Registrant’s Form 10-Q  filed on November 13, 2006)                                                                                                                                                                                                                                                                                                                       |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.3                     |       | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.4                     |       | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006)                                                                                                                                                                                                                                                                                                      |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1                     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.2                     |       | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.1 of Registrant’s Form 10-Q  filed on November 13, 2006)                                                                                                                                                                                                                                                                                                                       |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.3                     |       | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.4                     |       | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006)                                                                                                                                                                                                                                                                                                      |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1                    |       | Compensation of  Conflicts Committee Members                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 19.1                    |       | Code of Ethics  for Chief Executive Officer and Senior Finance Officers (incorporated by  reference to Exhibit 19.1 of Registrant’s annual report on Form 10-K filed on  March 20, 2007)                                                                                                                                                                                                                                                                                                                                |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 21.1                    |       | List of  Subsidiaries of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 21.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                                |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.1                    | —     | Certification of  Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                                          |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2                    | —     | Certification of  Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                                          |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 32.1                    | —     | Certification of  Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                                          |
|                    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 32.2                    | —     | Certification of  Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                           |

 

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*+*Denotes a management contract orcompensatory plan or arrangement.

*†*Portions of this exhibit have beenomitted pursuant to a request for confidential treatment.

 

----