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**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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

 

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

 

**OR**

 

**o****  TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**FORTHE TRANSITION PERIODFROM             TO**

 

**Commissionfile number:  001-33018**

 

**HilandHoldings GP, LP**

(Exact name ofRegistrant as specified in its charter)

 

| **DELAWARE**                                               | ** ** | **76-0828238**       |
|------------------------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of                           |       | (I.R.S. Employer     |
| incorporation or  organization)                            |       | Identification  No.) |
|                                                       |       |                 |
| **205  West Maple, Suite 1100**                       |       |                 |
| **Enid,  Oklahoma**                                        | ** ** | **73701**            |
| (Address of  principal executive offices)                  |       | (Zip Code)           |
|                                                       |       |                 |
| **(580)  242-6040**                                        |
| (Registrant’s  telephone number, including area code) |

 

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

 

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

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

 

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

 

The number of theregistrant’s outstanding equity units as of November 5, 2008 was21,607,500 common units.

 

 

 

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

 

**INDEX**

 
| **PART I. FINANCIAL INFORMATION**                                                              | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|
| Item  1. Financial Statements (Unaudited, except December 31, 2007 Balance  Sheet)             |       |
| Consolidated Balance Sheets                                                                         | 3          |
| Consolidated Statements of Operations                                                               | 4          |
| Consolidated Statements of Cash Flows                                                               | 5          |
| Consolidated Statement of Changes in Partners’ Equity  and Comprehensive Income                | 6          |
| Condensed Notes to Consolidated Financial Statements                                                | 7          |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 28         |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risks                                | 43         |
| Item 4. Controls  and Procedures                                                                    | 45         |
| **PART II. OTHER INFORMATION**                                                                 | 45         |
| Item 1. Legal  Proceedings                                                                          | 45         |
| Item 1A. Risk  Factors                                                                              | 46         |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                | 48         |
| Item 3. Defaults  Upon Senior Securities                                                            | 48         |
| Item 4.  Submission of Matters to a Vote of Security Holders                                        | 48         |
| Item 5. Other  Information                                                                          | 48         |
| Item 6. Exhibits                                                                                    | 48         |
| SIGNATURES                                                                                          | 51         |
| Certification  of CEO under Section 302                                                        |       |
| Certification  of CFO under Section 302                                                        |       |
| Certification  of CEO under Section 906                                                        |       |
| Certification  of CFO under Section 906                                                        |       |

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                        | ** ** | **September 30,**                                      | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                        | ** ** | **2008**                                                    | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                        | ** ** | **(unaudited)**                                             | ** ** | ** **            | ** ** |
| ** **                                                                                                                                        | ** ** | **(in thousands, except unit amounts)** | ** ** |
| **ASSETS**                                                                                                                                        |       |                                                        |       |                  |       |
| **Current assets:**                                                                                                                               |       |                                                        |       |                  |       |
| Cash and cash equivalents                                                                                                                         |       | $                                                           | 12,589     |                  | $          | 10,602 |   |
| Accounts receivable:                                                                                                                              |       |                                                        |       |                  |       |
| Trade - net of allowance for doubtful accounts of  $304 in 2008                                                                                   |       | 41,574                                                      |       | 31,842                |       |
| Affiliates                                                                                                                                        |       | 5,323                                                       |       | 1,178                 |       |
|                                                                                                                                              |       | 46,897                                                      |       | 33,020                |       |
| Fair value of derivative assets                                                                                                                   |       | 4,521                                                       |       | 2,718                 |       |
| Other current assets                                                                                                                              |       | 2,743                                                       |       | 1,420                 |       |
| Total current assets                                                                                                                              |       | 66,750                                                      |       | 47,760                |       |
|                                                                                                                                              |       |                                                        |       |                  |       |
| Property and equipment, net                                                                                                                       |       | 337,316                                                     |       | 323,073               |       |
| Intangibles, net                                                                                                                                  |       | 42,319                                                      |       | 46,937                |       |
| Fair value of derivative assets                                                                                                                   |       | 4,991                                                       |       | 418                   |       |
| Other assets, net                                                                                                                                 |       | 2,041                                                       |       | 2,098                 |       |
|                                                                                                                                              |       |                                                        |       |                  |       |
| **Total assets**                                                                                                                                  |       | $                                                           | 453,417    |                  | $          | 420,286 |   |
|                                                                                                                                              |       |                                                        |       |                  |       |
| **LIABILITIES AND PARTNERS’ EQUITY**                                                                                                         | ** ** | ** **                                                  | ** ** | ** **            | ** ** |
| **Current liabilities:**                                                                                                                          |       |                                                        |       |                  |       |
| Accounts payable                                                                                                                                  |       | $                                                           | 22,624     |                  | $          | 24,713 |   |
| Accounts payable-affiliates                                                                                                                       |       | 8,437                                                       |       | 7,957                 |       |
| Fair value of derivative liabilities                                                                                                              |       | 1,626                                                       |       | 8,238                 |       |
| Accrued liabilities and other                                                                                                                     |       | 4,124                                                       |       | 2,075                 |       |
| Total current liabilities                                                                                                                         |       | 36,811                                                      |       | 42,983                |       |
|                                                                                                                                              |       |                                                        |       |                  |       |
| Commitments and contingencies (Note 8)                                                                                                            |       |                                                        |       |                  |       |
| Long-term debt                                                                                                                                    |       | 266,633                                                     |       | 226,459               |       |
| Fair value of derivative liabilities                                                                                                              |       | —                                                      |       | 141                   |       |
| Asset retirement obligation                                                                                                                       |       | 2,417                                                       |       | 2,159                 |       |
| Minority interests                                                                                                                                |       | 126,912                                                     |       | 126,409               |       |
|                                                                                                                                              |       |                                                        |       |                  |       |
| **Partners’ equity**                                                                                                                         |       |                                                        |       |                  |       |
| Common unitholders (21,607,500 and 21,603,000 units  issued and outstanding at September 30, 2008 and December 31, 2007,  respectively) |       | 18,435                                                      |       | 25,560                |       |
| Accumulated other comprehensive income                                                                                                            |       | 2,209                                                       |       | (3,425                | )          |
| **Total partners’ equity**                                                                                                                   |       | 20,644                                                      |       | 22,135                |       |
|                                                                                                                                              |       |                                                        |       |                  |       |
| **Total liabilities and partners’ equity**                                                                                                   |       | $                                                           | 453,417    |                  | $          | 420,286 |   |

 

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

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Statements of Operations**

**Forthe Three and Nine Months Ended (unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended September 30,**             | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                                             | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                   | ** ** | **(in thousands, except per unit amounts)** | ** ** |
| **Revenues:**                                                                | ** ** | ** **                                                           | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream operations                                                         |       |                                                                 |       |                                                    |       |   |   |   |   |
| Third parties                                                                |       | $                                                                    | 107,158    |                                                    | $          | 65,777 |   | $ | 308,625 |   | $ | 189,301 |   |
| Affiliates                                                                   |       | 7,390                                                                |       | 654                                                     |       | 10,433 |   | 2,390 |   |
| Compression services, affiliate                                              |       | 1,205                                                                |       | 1,205                                                   |       | 3,615 |   | 3,615 |   |
| Total revenues                                                               |       | 115,753                                                              |       | 67,636                                                  |       | 322,673 |   | 195,306 |   |
|                                                                         |       |                                                                 |       |                                                    |       |   |   |   |   |
| **Operating costs and expenses:**                                            | ** ** | ** **                                                           | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream purchases (exclusive of items shown separately below)              | ** ** | 45,616                                                               | ** ** | 31,267                                                  | ** ** | 139,258 | ** ** | 98,056 | ** ** |
| Midstream purchases - affiliate (exclusive of items  shown separately below) |       | 36,279                                                               |       | 14,522                                                  |       | 99,328 |   | 39,264 |   |
| Operations and maintenance                                                   |       | 7,881                                                                |       | 6,157                                                   |       | 22,201 |   | 16,108 |   |
| Depreciation, amortization and accretion                                     |       | 9,842                                                                |       | 7,870                                                   |       | 28,513 |   | 22,222 |   |
| Bad debt                                                                     |       | (7,799                                                               | )          | —                                                  |       | 304 |   | — |   |
| General and administrative expenses                                          |       | 2,597                                                                |       | 2,054                                                   |       | 7,615 |   | 6,383 |   |
| Total operating costs and expenses                                           |       | 94,416                                                               |       | 61,870                                                  |       | 297,219 |   | 182,033 |   |
| Operating income                                                             |       | 21,337                                                               |       | 5,766                                                   |       | 25,454 |   | 13,273 |   |
| **Other income (expense):**                                                  | ** ** | ** **                                                           | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and other income                                                    |       | 99                                                                   |       | 105                                                     |       | 276 |   | 325 |   |
| Amortization of deferred loan costs                                          |       | (169                                                                 | )          | (136                                                    | )          | (493 | ) | (357 | ) |
| Interest expense                                                             |       | (3,279                                                               | )          | (3,133                                                  | )          | (9,915 | ) | (7,538 | ) |
| Other income (expense), net                                                  |       | (3,349                                                               | )          | (3,164                                                  | )          | (10,132 | ) | (7,570 | ) |
| **Income before minority interest in loss of  Hiland Partners, LP**     |       | 17,988                                                               |       | 2,602                                                   |       | 15,322 |   | 5,703 |   |
| Minority interest in income of Hiland Partners, LP                           | ** ** | (6,800                                                               | )          | (867                                                    | )          | (4,402 | ) | (2,080 | ) |
| **Net income**                                                               |       | $                                                                    | 11,188     |                                                    | $          | 1,735 |   | $ | 10,920 |   | $ | 3,623 |   |
| ** **                                                                   | ** ** |                                                                 |       |                                                    |       |   |   |   |   |
| **Net income per limited partners’ unit - basic**                       | ** ** | $                                                                    | 0.52       |                                                    | $          | 0.08 |   | $ | 0.51 |   | $ | 0.17 |   |
| **Net income per limited partners’ unit - diluted**                     | ** ** | $                                                                    | 0.52       |                                                    | $          | 0.08 |   | $ | 0.51 |   | $ | 0.17 |   |
| **Weighted average limited partners’ units  outstanding - basic**       | ** ** | 21,603                                                               |       | 21,600                                                  |       | 21,603 |   | 21,600 |   |
| **Weighted average limited partners’ units  outstanding - diluted**     | ** ** | 21,612                                                               | ** ** | 21,609                                                  | ** ** | 21,610 | ** ** | 21,610 | ** ** |

 

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

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedStatements of Cash Flows**

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

 
| ** **                                                                         | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **2008**                | ** ** | **2007**               | ** ** |
| ** **                                                                         | ** ** | **(in thousands)** | ** ** |
| **Cash flows from operating activities:**                                          |       |                    |       |                   |       |
| Net income                                                                         |       | $                       | 10,920     |                   | $          | 3,623 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                    |       |                   |       |
| Depreciation and amortization                                                      |       | 28,411                  |       | 22,141                 |       |
| Accretion of asset retirement obligation                                           |       | 102                     |       | 81                     |       |
| Amortization of deferred loan cost                                                 |       | 493                     |       | 357                    |       |
| Gain on derivative transactions                                                    |       | (3,685                  | )          | (510                   | )          |
| Unit based compensation                                                            |       | 1,274                   |       | 1,033                  |       |
| Bad debt                                                                           |       | 304                     |       | —                 |       |
| Gain on sale of assets                                                             |       | (12                     | )          | —                 |       |
| Increase in other assets                                                           |       | (72                     | )          | —                 |       |
| Minority interest in income of Hiland Partners, LP                                 |       | 4,402                   |       | 2,080                  |       |
| (Increase) decrease in current assets:                                             |       |                    |       |                   |       |
| Accounts receivable - trade                                                        |       | (10,036                 | )          | 489                    |       |
| Accounts receivable - affiliates                                                   |       | (4,145                  | )          | 379                    |       |
| Other current assets                                                               |       | (1,322                  | )          | 84                     |       |
| Increase (decrease) in current liabilities:                                        |       |                    |       |                   |       |
| Accounts payable - trade                                                           |       | (2,813                  | )          | (2,543                 | )          |
| Accounts payable - affiliates                                                      |       | 480                     |       | 675                    |       |
| Accrued liabilities and other                                                      |       | 1,241                   |       | 286                    |       |
| **Net cash provided by operating activities**                                      |       | 25,542                  |       | 28,175                 |       |
| **Cash flows from investing activities:**                                          |       |                    |       |                   |       |
| Additions to property and equipment                                                |       | (37,164                 | )          | (61,940                | )          |
| Proceeds from disposals of property and equipment                                  |       | 18                      |       | —                 |       |
| **Net cash used in investing activities**                                          |       | (37,146                 | )          | (61,940                | )          |
| **Cash flows from financing activities:**                                          |       |                    |       |                   |       |
| Proceeds from long-term borrowings                                                 |       | 41,350                  |       | 54,100                 |       |
| Increase in deferred offering cost                                                 |       | (7                      | )          | (157                   | )          |
| Debt issuance costs                                                                |       | (356                    | )          | (494                   | )          |
| Proceeds from Hiland Partners, LP unit options  exercise                           |       | 1,031                   |       | 1,024                  |       |
| Redemption of vested phantom units                                                 |       | (35                     | )          | —                 |       |
| Payments on capital lease obligations                                              |       | (369                    | )          | (178                   | )          |
| Minority interest cash distributions to unitholders  of Hiland Partners, LP        |       | (9,863                  | )          | (8,447                 | )          |
| Cash distributions to unitholders                                                  |       | (18,160                 | )          | (13,724                | )          |
| **Net cash provided by financing activities**                                      |       | 13,591                  |       | 32,124                 |       |
|                                                                               |       |                    |       |                   |       |
| Increase (decrease) for the period                                                 |       | 1,987                   |       | (1,641                 | )          |
| Beginning of period                                                                |       | 10,602                  |       | 10,569                 |       |
| **End of period**                                                                  |       | $                       | 12,589     |                   | $          | 8,928 |   |
| Supplementary information                                                          |       |                    |       |                   |       |
| Cash paid for interest, net of amounts capitalized                                 |       | $                       | 9,734      |                   | $          | 7,489 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements

 

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**HilandHoldings GP, LP**

**Consolidated Statement of Changes inPartners’ Equity and Comprehensive Income**

**Forthe Nine Months Ended September 30, 2008 (unaudited)**

 
| ** **                                                                           | ** ** | ** **              | ** ** | **Accumulated**        | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|------------|------------|-------------------|------------|
| ** **                                                                           | ** ** | **Common**              | ** ** | **Other**              | ** ** | ** ** | ** ** | **Total**         | ** ** |
| ** **                                                                           | ** ** | **Unitholders**         | ** ** | **Comprehensive**      | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                           | ** ** | **Interest**            | ** ** | **Income (loss)** | ** ** | **Total**  | ** ** | **Income**        | ** ** |
| ** **                                                                           | ** ** | **(in thousands)** | ** ** |
| **Balance, January 1, 2008**                                                    |       | $                       | 25,560     |                   | $          | (3,425     | )          | $                 | 22,135     |   |   |   |
| ** **                                                                           |       |                    |       |                   |       |       |       |              |       |   |   |   |
| Periodic cash distributions                                                          |       | (18,160                 | )          | —                 |       | (18,160    | )          |              |       |
|                                                                                 |       |                    |       |                   |       |       |       |              |       |
| Unit based compensation                                                              |       | 115                     |       | —                 |       | 115        |       |              |       |
|                                                                                 |       |                    |       |                   |       |       |       |              |       |
| Other comprehensive income reclassified to income on  closed derivative transactions |       | —                  |       | 3,877                  |       | 3,877      |       | $                 | 3,877      |   |
|                                                                                 |       |                    |       |                   |       |       |       |              |       |   |
| Change in fair value of derivatives                                                  |       | —                  |       | 1,757                  |       | 1,757      |       | 1,757             |       |
|                                                                                 |       |                    |       |                   |       |       |       |              |       |
| Net income                                                                           |       | 10,920                  |       | —                 |       | 10,920     |       | 10,920            |       |
|                                                                                 |       |                    |       |                   |       |       |       |              |       |
| Comprehensive income                                                                 |       |                    |       |                   |       |       |       | $                 | 16,554     |   |
|                                                                                 |       |                    |       |                   |       |       |       |              |       |   |
| **Balance, September 30, 2008**                                                 |       | $                       | 18,435     |                   | $          | 2,209      |       | $                 | 20,644     |   |   |   |

 

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

 

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**HILANDHOLDINGS GP, LP**

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

** **

**THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2008 and 2007**

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

** **

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

** **

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

 

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

 

Our general partner,Hiland Partners GP Holdings, LLC manages our operations and activities,including, among other things, paying our expenses and establishing the quarterlycash distribution levels for our common units and reserves that our generalpartner determines, in good faith, are necessary or appropriate to provide forthe conduct of our business, to comply with applicable law, any of our debtinstruments or other agreements or to provide for future distributions to ourunitholders for any one or more of the upcoming four quarters.

 

Hiland Partners, aDelaware limited partnership, was formed in October 2004 to acquire andoperate certain midstream natural gas plants, gathering systems and compressionand water injection assets located in the states of Oklahoma, North Dakota,Wyoming, Texas and Mississippi that were previously owned by Continental Gas, Inc.(“CGI”) and Hiland Partners, LLC. Hiland Partners commenced operations on February 15,2005, and concurrently with the completion of its initial public offering, CGIcontributed a substantial portion of its net assets to Hiland Partners. Thetransfer of ownership of net assets from CGI to Hiland Partners represented areorganization of entities under common control and was recorded at historicalcost. CGI was formed in 1990 as a wholly owned subsidiary of ContinentalResources, Inc. (“CLR”).

 

CGI. operated in onesegment, midstream, which involved the purchasing, gathering, compressing,dehydrating, treating, processing and marketing of natural gas andfractionating and marketing of natural gas liquids, or NGLs. CGI. historicallyhas owned all of Hiland Partners’ natural gas gathering, processing, treatingand fractionation assets other than the Worland,  Bakken and Woodford Shale gathering systems.Hiland Partners, LLC historically owned the Worland gathering system andcompression services assets, which Hiland Partners acquired on February 15,2005, and the Bakken gathering system. Since its initial public offering,Hiland Partners has operated in midstream and compression services segments. OnSeptember 26, 2005, Hiland Partners acquired Hiland Partners, LLC, whichat such time owned the Bakken gathering system, for $92.7 million,$35.0 million of which was used to retire outstanding Hiland Partners, LLCindebtedness. On May 1, 2006, Hiland Partners acquired the Kinta Areagathering assets from Enogex Gas Gathering, L.L.C., consisting of certaineastern Oklahoma gas gathering assets, for $96.4 million.  Hiland Partners financed this acquisitionwith $61.2 million of borrowings from its credit facility and $35.0 million ofproceeds from the issuance to Hiland Partners GP, LLC, its general partner, of761,714 common units and 15,545 general partner equivalent units, both at$45.03 per unit. Hiland Partners began construction of the Woodford Shalegathering system in the first quarter of 2007. As of September 30, 2008, Hiland Partners has investedapproximately $39.8 million in the gathering system.

 

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

 

***Principles ofConsolidation***

*** ***

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

 

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***Use of Estimates***

 

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

 

***Fair Value of Financial Instruments***

*** ***

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

 

***Commodity Risk Management***

*** ***

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

 

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

 

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

 

***Comprehensive Income***

*** ***

Comprehensive incomeincludes net income and other comprehensive income, which includes, but is notlimited to, changes in the fair value of derivative financial instruments.Pursuant to SFAS 133, for derivatives qualifying as accounting hedges, theeffective portion of changes in fair value is recognized in partners’ equity asaccumulated other comprehensive income (loss) and reclassified to earnings whenthe underlying hedged physical transaction closes, to the extent of ourinterest in Hiland Partners. Our comprehensive income for the three and ninemonths ended September 30, 2008 and 2007 is presented in the table below:

 

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| ** **                                             | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income                                             |       | $                                                        | 11,188     |                                                    | $          | 1,735 |   | $ | 10,920 |   | $ | 3,623 |   |
| Closed  derivative transactions reclassified to income |       | 834                                                      |       | (511                                                    | )          | 3,877 |   | (1,346 | ) |
| Change in fair  value of derivatives                   |       | 7,862                                                    |       | (15                                                     | )          | 1,757 |   | (808 | ) |
| Comprehensive  income                                  |       | $                                                        | 19,884     |                                                    | $          | 1,209 |   | $ | 16,554 |   | $ | 1,469 |   |

 

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

 

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

 

***Minority Interests***

*** ***

The minority interest onour consolidated balance sheets as of September 30, 2008 and December 31,2007 reflects the outside ownership interest of Hiland Partners. Minorityinterest in income is calculated by multiplying the minority interest owners’proportionate ownership of limited partner units in Hiland Partners by thelimited partners’ allocation of Hiland Partners’ net income. Hiland Partners’net income is allocated to its limited partners and its general partner basedon the proportionate share of the cash distributions declared for the period,with adjustments 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 theminority interest balance on the consolidated balance sheet.

 

***Contributions to Subsidiary***

*** ***

The Partnership directlyand indirectly owns all of the equity interests in Hiland Partners GP, LLC, thegeneral partner of Hiland Partners. Hiland Partners GP, LLC is required to makecontributions to Hiland Partners each time Hiland Partners issues common unitsin order to maintain its 2% general partner ownership in Hiland Partners.Hiland Holdings was required to contribute $5 and $6 for the three months endedSeptember 30, 2008 and 2007, respectively, and was required to contribute$28 and $27 for the nine months ended September 30, 2008 and 2007,respectively.

 

***Recent Accounting Pronouncements***

*** ***

On April 25, 2008,the Financial Accounting Standards Board (“FASB”) 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 will be effectiveas of January 1, 2009 and will apply only to intangible assets acquiredafter that date. Retroactive application to previously acquired intangibleassets is prohibited.  The adoption of FSP 142-3 is not expected to have amaterial impact on our financial position, results of operations or cash flows.

 

On March 19, 2008,the FASB issued SFAS No. 161, “Disclosures about Derivative Instrumentsand Hedging Activities”, an amendment of SFAS 133 (“SFAS 161”). SFAS 161 isintended to improve transparency in financial reporting by requiring enhanceddisclosures of an entity’s derivative instruments and hedging activities andtheir effects on the entity’s financial position, financial performance, andcash flows. SFAS 161 is effective prospectively for financial statements issuedfor fiscal years and interim periods beginning after November 15, 2008,with early application encouraged. SFAS 161 encourages, but does not require,comparative disclosures for periods prior to its initial adoption. SFAS 161amends the current qualitative and quantitative disclosure requirements forderivative instruments and hedging activities set forth in SFAS 133 andgenerally increases the level of aggregation/disaggregation that will berequired in an entity’s financial statements. We are currently reviewing SFAS161 to determine the effect it will have on our financial statements anddisclosures therein.

 

On March 12, 2008,the Emerging Issues Task Force (“EITF”) reached consensus opinion on EITF Issue07-4, “Application of the two-class method under FASB Statement No. 128,Earnings per Share, to Master Limited Partnerships” (“EITF 07-4”), which theFASB ratified at its March 26, 2008 meeting. EITF 07-4 requires thecalculation of a Master Limited Partnership’s (“MLPs”) net earnings per limitedpartner unit for each period presented according to distributions declared andparticipation rights in undistributed earnings as if all of the earnings forthat period had been distributed. In periods with undistributed earnings abovespecified levels, the calculation per the two-class method results in anincreased allocation of such undistributed earnings to the general partner anda dilution of earnings to the limited partners. EITF 07-4 is effective forfiscal years beginning after December 15, 2008, and is to be 

 

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applied retrospectivelyto all periods presented. Early application is not permitted. We will apply therequirements of EITF 07-4 as it pertains to MLPs upon its adoption during thequarter ended March 31, 2009 and do not expect a significant impact whenadopted.

 

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

 

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

 

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

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 defines fair value as the price thatwould be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date,establishes a framework for measuring fair value in generally accepted accountingprinciples (“GAAP”) such as fair value hierarchy used to classify the source ofinformation used in fair value measurements (i.e., market based or non-marketbased) and expands disclosure about fair value measurements based on theirlevel in the hierarchy.  SFAS 157 appliesto derivatives and other financial instruments, which SFAS 133 requires bemeasured at fair value at initial recognition and for all subsequent periods.SFAS 157 establishes a fair value hierarchy which requires an entity tomaximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value. SFAS 157’s hierarchy defines three levels ofinputs that may be used to measure fair value. Level 1 refers to assets thathave observable market prices, level 2 assets do not have an “observable price”but do have inputs that are based on such prices in which components haveobservable data points and level 3 refers to assets in which one or more of theinputs do not have observable prices and calibrated model parameters, valuationtechniques or management’s assumptions are used to derive the fair value. SFAS157 is effective for financial statements issued for fiscal years beginningafter November 15, 2007 and interim periods within those fiscal years. Weelected to implement SFAS 157 prospectively in the first quarter of 2008 withthe one-year deferral permitted by FASB Staff Position (FSP) 157-2 fornonfinancial assets and nonfinancial liabilities measured at fair value, exceptthose that are recognized or disclosed on a recurring basis (at leastannually). The deferral applies to nonfinancial assets and liabilities measuredat fair value in a business combination; impaired properties, plants andequipment; intangible assets and goodwill; and initial recognition of assetretirement obligations and restructuring costs for which we use fair value. Wedo not expect any significant impact to our consolidated financial statementswhen we implement SFAS 157 for these assets and liabilities. See Note 5 “FairValue Measurements of Financial Instruments.”

 

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

** **

Propertyand equipment consisted of the following for the periods indicated:

 

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| ** **                                       | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Land                                             |       | $                      | 298        |                  | $          | 295 |   |
| Construction in  progress                        |       | 8,940                  |       | 12,030                |       |
| Midstream  pipeline, plants and compresors       |       | 396,765                |       | 356,491               |       |
| Compression and  water injection equipment       |       | 19,373                 |       | 19,258                |       |
| Other                                            |       | 4,558                  |       | 3,958                 |       |
|                                             |       | 429,934                |       | 392,032               |       |
| Less:  accumulated depreciation and amortization |       | 92,618                 |       | 68,959                |       |
|                                             |       | $                      | 337,316    |                  | $          | 323,073 |   |

 

During the three and ninemonths ended September 30, 2008, we capitalized interest of $5 and $160,respectively. We capitalized $828 and $2,281 interest during the three and ninemonths ended September 30, 2007, respectively.

 

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

 

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

 

| Asset retirement  obligation, January 1, 2008    |   | $   | 2,159  |   |
|-------------------------------------------------------|--------|-----|--------|--------|
| Add: additions  on leased locations                   |   | 156 |   |
| Add: accretion  expense                               |   | 102 |   |
| Asset retirement  obligation, September 30, 2008 |   | $   | 2,417  |   |

 

**Note 3:   Intangible Assets**

** **

Intangible assets consistof the acquired value of customer relationships, existing contracts to sellnatural gas and other NGLs and compression contracts, which do not havesignificant residual value. The customer relationships and the contracts arebeing amortized over their estimated lives of ten years. We review intangibleassets for impairment whenever events or circumstances indicate that thecarrying amounts may not be recoverable. If such a review should indicate thatthe carrying amount of intangible assets is not recoverable, we reduce thecarrying amount of such assets to fair value based on the discounted probablecash flows of the intangible assets. No impairments of intangible assets wererecorded during the three and nine months ended September 30, 2008 or2007.

 

Intangible assetsconsisted of the following for the periods indicated:

 

| ** **                     | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                     | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Gas sales  contracts           |       | $                      | 32,564     |                  | $          | 32,564 |   |
| Compression  contracts         |       | 18,515                 |       | 18,515                |       |
| Customer  relationships        |       | 10,492                 |       | 10,492                |       |
|                           |       | 61,571                 |       | 61,571                |       |
| Less accumulated  amortization |       | 19,252                 |       | 14,634                |       |
| Intangible  assets, net        |       | $                      | 42,319     |                  | $          | 46,937 |   |

 

During each of the threemonths ended September 30, 2008 and 2007, we recorded $1,540,respectively, of amortization expense. During each of the nine months ended September 30, 2008 and 2007,we recorded $4,618, respectively, of amortization expense.  Estimated aggregate amortization expense forthe remainder of 2008 is $1,539 and $6,157 for each of the four succeedingfiscal years from 2009 through 2012 and a total of $16,151 for all yearsthereafter.

 

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**Note 4: Derivatives**

 

Hiland Partners hasentered into certain derivative contracts that are classified as cash flowhedges in accordance with SFAS 133 and relate to forecasted sales in 2008, 2009and  a mark-to-market cash flow derivativewhich relates to forecasted sales in 2010. The 2010 hedge does not qualify forcash flow hedge accounting.  HilandPartners entered into these financial swap instruments to hedge forecastednatural gas and natural gas liquids (NGLs) sales against the variability inexpected future cash flows attributable to changes in commodity prices. Underthese contractual swap agreements with Hiland Partners’ counterparty, HilandPartners receives a fixed price and pays a floating price or Hiland Partnerspays a fixed price and receives a floating price based on certain indices forthe relevant contract period as the underlying natural gas is sold or purchasedor NGL is sold.

 

Hiland Partners formallydocuments all relationships between hedging instruments and the items being hedged,including its risk management objective and strategy for undertaking thehedging transactions. This includes matching the natural gas and NGL futures,the “sold fixed for floating price” or “buy fixed for floating price”contracts, to the forecasted transactions. Hiland Partners assesses, both atthe inception of the hedge and on an ongoing basis, whether the derivatives arehighly effective in offsetting changes in the fair value of hedged items.Highly effective is deemed to be a correlation range from 80% to 125% of thechange in cash flows of the derivative in offsetting the cash flows of thehedged transaction. If it is determined that a derivative is not highlyeffective as a hedge or it has ceased to be a highly effective hedge, due tothe loss of correlation between changes in natural gas or NGL reference pricesunder a hedging instrument and actual natural gas or NGL prices, HilandPartners will discontinue hedge accounting for the derivative and subsequentchanges in fair value for the derivative will be recognized immediately intoearnings. Hiland Partners assesses effectiveness using regression analysis andmeasure ineffectiveness using the dollar offset method.

 

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

 

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

 

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

 

| ** **                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                           | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net gains  (losses) on closed/settled transactions reclassified from (to) accumulated  other comprehensive income    |       | $                                | (1,395     | )                               | $          | 854 |   | $ | (6,478 | ) | $ | 2,309 |   |
| Increases  (decreases) in fair values of open derivatives recorded to (from) accumulated  other comprehensive income |       | $                                | 13,218     |                            | $          | (26 | ) | $ | 2,965 |   | $ | (1,356 | ) |
| Unrealized  non-cash gains on ineffective portions of qualifying derivative transactions                             |       | $                                | 133        |                            | $          | 33 |   | $ | 128 |   | $ | 24 |   |
| Unrealized  non-cash gains on non-qualifying derivatives                                                             |       | $                                | 5,487      |                            | $          | 305 |   | $ | 3,557 |   | $ | 486 |   |

 

At September 30,2008, our accumulated other comprehensive income related to qualifyingderivatives was $2,209. Of this amount, we anticipate $1,632 will bereclassified to earnings during the next twelve months and $577 will bereclassified to earnings in subsequent periods.

 

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

 

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| ** **                                        | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                        | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Fair value of  derivative assets - current        |       | $                      | 4,521      |                  | $          | 2,718 |   |
| Fair value of  derivative assets - long term      |       | 4,991                  |       | 418                   |       |
| Fair value of  derivative liabilities - current   |       | (1,626                 | )          | (8,238                | )          |
| Fair value of  derivative liabilities - long term |       | —                 |       | (141                  | )          |
| Net fair value  of derivatives                    |       | $                      | 7,886      |                  | $          | (5,243 | ) |

 

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

 

| ** **                                                 | ** ** | ** **  | ** ** | **Average**           | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------|------------|-------------|------------|-----------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | ** **  | ** ** | **Fixed**             | ** ** | **Asset**           | ** ** |
| **Description and Production Period**       | ** ** | **Volume**  | ** ** | **Price**             | ** ** | **(Liability)**     | ** ** |
| ** **                                                 | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**  | ** ** | ** **          | ** ** |
| Natural Gas -  Sold Fixed for Floating Price Swaps         |       |        |       |                  |       |                |       |
| October 2008  - September 2009                   |       | 2,097,000   |       | $                     | 7.42       |                | $          | 4,521 |   |
| October 2009  - December 2009                    |       | 534,000     |       | $                     | 7.30       |                | 1,016      |   |
| January 2010  - December 2010                    |       | 2,136,000   |       | $                     | 10.50      |                | 3,975      |   |
|                                                       |       |        |       |                  |       | $                   | 9,512      |   |
|                                                       |       |        |       |                  |       |                |       |
| ** **                                                 | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**  | ** ** | ** **          | ** ** |
| Natural Gas -  Buy Fixed for Floating Price Swaps          |       |        |       |                  |       |                |       |
| October 2008  - December 2008                    |       | 180,288     |       | $                     | 6.93       |                | $          | (396 | ) |
|                                                       |       |        |       |                  |       |                |       |
| ** **                                                 | ** ** | **(Bbls)**  | ** ** | **(per Gallon)** | ** ** | ** **          | ** ** |
| Natural Gas  Liquids - Sold Fixed for Floating Price Swaps |       |        |       |                  |       |                |       |
| October 2008  - December 2008                    |       | 110,442     |       | $                     | 1.31       |                | $          | (1,230 | ) |

 

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

** **

We adopted SFAS No. 157,“Fair Value Measurements” (“SFAS 157”) beginning in the first quarter of 2008.SFAS 157 defines fair value as the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date, establishes a framework for measuringfair value in GAAP such as fair value hierarchy used to classify the source ofinformation used in fair value measurements (i.e., market based or non-marketbased) and expands disclosure about fair value measurements based on theirlevel in the hierarchy.  SFAS 157 appliesto derivatives and other financial instruments, which SFAS 133 requires bemeasured at fair value at initial recognition and for all subsequent periods.SFAS 157 establishes a fair value hierarchy which requires an entity tomaximize the use of observable inputs and minimize the use of unobservableinputs when measuring fair value. SFAS 157’s hierarchy defines three levels ofinputs that may be used to measure fair value. Level 1 refers to assets thathave observable market prices, level 2 assets do not have an “observable price”but do have inputs that are based on such prices in which components haveobservable data points and level 3 refers to assets in which one or more of theinputs do not have observable prices and calibrated model parameters, valuationtechniques or management’s assumptions are used to derive the fair value.

 

We use the fair valuemethodology outlined in SFAS 157 to value assets and liabilities for ouroutstanding fixed price cash flow swap derivative contracts. Valuations of ournatural gas and propane derivative contracts are based on published forwardprice curves for natural gas and propane and, as such, are defined as Level 2fair value hierarchy assets and liabilities. There are no published forwardprice curves for butanes or natural gasoline, and therefore, our butanes andnatural gasoline derivative contracts are defined as Level 3 fair valuehierarchy assets and liabilities. We value our butanes and natural gasolinederivative contracts based on calibrated model parameters relative to forwardpublished price curves for crude oil and comparative mark-to-market valuesreceived from our counterparty.  Thefollowing table represents the fair value hierarchy for Hiland Partners’ assetsand liabilities at September 30, 2008:

 

| ** **                               | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Commodity -based  derivative assets      |       | $                | —     |             | $          | 9,512            |       | $         | —     |   | $ | 9,512 |   |
| Commodity -based  derivative liabilities |       | —           |       | (1,023           | )          | (603             | )          | (1,626    | )          |
| Total                                    |       | $                | —     |             | $          | 8,489            |       | $         | (603       | ) | $ | 7,886 |   |

 

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

 

| Balance,  January 1, 2008                    |   | $     | (4,489 | ) |
|---------------------------------------------------|--------|-------|--------|---|
| Cash settlements  from other comprehensive income |   | 4,850 |   |
| Net change in  other comprehensive income         |   | (964  | )      |
| Balance,  September 30, 2008                 |   | $     | (603   | ) |

** **

**Note 6: Long-TermDebt**

** **

| ** **                       | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|----------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                       | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Hiland Partners  Credit Facility |       | $                      | 262,064    |                  | $          | 221,064 |   |
| Hiland Holdings  Credit Facility |       | 705                    |       | 355                   |       |
| Capital lease  obligations       |       | 5,216                  |       | 5,585                 |       |
|                             |       | 267,985                |       | 227,004               |       |
| Less current  portion:           |       |                   |       |                  |       |
| Capital lease  obligations       |       | 647                    |       | 545                   |       |
| Hiland Holdings  Credit Facility |       | 705                    |       | —                |       |
| Long-term debt                   |       | $                      | 266,633    |                  | $          | 226,459 |   |

** **

***Hiland Partners Credit Facility***

*** ***

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

 

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

 

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

 

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

 

Indebtedness under thecredit facility will bear interest, at Hiland Partners’ option, at either (i) anAlternate Base Rate plus an applicable margin ranging from 50 to 125 basispoints per annum or (ii) LIBOR plus an applicable margin ranging from 150to 225 basis points per annum based on its ratio of consolidated funded debt toEBITDA. The Alternate Base Rate is a rate per annum equal to the greatest of (a) thePrime Rate in effect on such day, (b) the base CD rate in effect on suchday plus 1.50% and (c) the Federal Funds effective rate in effect on suchday plus 1⁄2 of 1%. We have 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 any step-upperiod, the applicable margin with respect to loans under the credit facilitywill be increased by 35 basis points per annum and the 

 

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unused commitment fee will be increased by 12.5 basis points per annum.At September 30, 2008, the interest rate on outstanding borrowings fromHiland Partners’ credit facility was 4.76%.

 

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

 

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

 

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

 

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

 

As of September 30,2008, Hiland Partners had $262.1 million outstanding under this creditfacility and was in compliance with all of the financial covenants contained inthe credit facility.

 

***Hiland Holdings Credit Facility***

*** ***

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

 

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

 

Indebtedness under thecredit facility bears interest, at our option, at either (i) an alternatebase rate plus an applicable margin ranging from 100 to 150 basis points perannum or (ii) LIBOR plus an applicable margin ranging from 200 to 250basis points per annum in each case based on our ratio of consolidated fundeddebt to EBITDA. The alternate base rate is equal to the greatest of (a) theprime rate in effect on such day, (b) the base CD rate in effect on suchday plus 1.50% and (c) the federal funds effective rate in effect on suchday plus 1⁄2 of 1%. We have 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 to2.0%. A commitment fee ranging from 25 to 50 basis points per annum based onour ratio of consolidated funded debt to EBITDA will be payable on the averagedaily unused portion of the credit facility for the quarter most recentlyended. At September 30, 2008, the interest rate on outstanding borrowings fromour credit facility was 4.49%.

 

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

 

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

 

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

 

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

 

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

 

As of September 30,2008, we had $0.7 million outstanding under this credit facility and werein compliance with our financial covenants. The outstanding $0.7 million, which matures on September 25,2009,  is included in accrued liabilitiesand other in the balance sheet.

 

***Capital Lease Obligations***

*** ***

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

 

During the three and ninemonths ended September 30, 2008, Hiland Partners made principal paymentsof $134 and $369, respectively, on the above described capital leaseobligations.  The current portion of thecapital lease obligations presented in the table above is included in accruedliabilities and other in the balance sheet.

 

**Note 7:  Share-Based Compensation**

** **

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

*** ***

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

 

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

 

As provided for in thelong-term incentive plan, each non-employee board member of Hiland Partners GPHoldings, LLC on each anniversary date of the initial award is entitled toreceive an additional 1,000 restricted common units. Accordingly, we issued atotal of 6,000 restricted units to our six non-employee board members duringthe three and nine months ended September 30, 2008.  Also during thethree months ended September 30, 2008, a total of 4,500 restricted unitsissued to non-employee board members in 2006 and 2007 vested and were convertedinto common units.  Non-cash unit basedcompensation expense related to restricted units issued is to be recognized overtheir respective four-year vesting period on the graded vesting attributionmethod. The following table summarizes information about our restricted unitsfor the nine months ended September 30, 2008.

 

| ** **                             | ** ** | ** ** | ** ** | **Weighted**        | ** ** |
|----------------------------------------|------------|------------|------------|---------------------|------------|
| ** **                             | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Restricted Units**              | ** ** | **Units**  | ** ** | **Date ($)**   | ** ** |
|                                   |       |       |       |                |       |
| Non-vested at  January 1, 2008    |       | 15,000     |       | $                   | 23.30      |   |
| Granted                                |       | 6,000      |       | $                   | 20.74      |   |
| Vested                                 |       | (4,500     | )          | $                   | 22.75      |   |
| Forfeited or  expired                  |       | —     | ** ** | —              | ** ** |
| Non-vested at  September 30, 2008 |       | 16,500     |       | $                   | 22.52      |   |

 

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We recorded non-cashcompensation expense related to the restricted units of $38 and $115 for thethree and nine months ended September 30, 2008, respectively, and $33 and$96 for the three and nine months ended September 30, 2007, respectively.We will record additional non-cash unit based compensation expense of $130 overthe next four years.

 

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

 

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

 

Hiland Partners GP, LLC’sboard of directors or compensation committee may, in their discretion,terminate, suspend or discontinue the long-term incentive plan at any time withrespect to any units for which a grant has not yet been made. Hiland PartnersGP, LLC’s board of directors or its compensation committee also has the rightto alter or amend the long-term incentive plan or any part of the plan fromtime to time, including increasing the number of units that may be granted,subject to unitholder approval if required by the exchange upon which thecommon units are listed at that time. No change in any outstanding grant may bemade, however, that would materially impair the rights of the participantwithout the consent of the participant. Under the unit option grant agreement,granted options of common units vest and become exercisable in one-thirdincrements on the anniversary of the grant date over three years. Vestedoptions are exercisable within the option’s contractual life of ten years afterthe grant date. Restricted common units granted vest and become exercisable inone-fourth increments on the anniversary of the grant date over four years. Arestricted unit is a common unit that is subject to forfeiture, and uponvesting, the grantee receives a common unit that is not subject to forfeiture.Distributions on unvested restricted common units are held in trust by HilandPartners’ general partner until the units vest, at which time the distributionsare distributed to the grantee. Granted phantom common units are generally moreflexible than restricted units and vesting periods and distribution rights mayvary with each grant. A phantom unit is a common unit that is subject toforfeiture and is not considered issued until it vests. Upon vesting, holdersof phantom units will receive (i) a common unit that is not subject toforfeiture, cash in lieu of the delivery of such unit equal to the fair marketvalue of the unit on the vesting date, or a combination thereof, at thediscretion of our general partner’s board of directors and (ii) thedistributions held in trust, if applicable, related to the vested units.

 

*PhantomUnits. * On August 7, 2008, Hiland Partnersgranted 7,500 phantom units to Mr. Kent C. Christopherson, its ChiefOperating Officer, appointed on August 4, 2008, and on July 31, 2008,Hiland Partners granted 3,000 phantom units to a key employee.  These phantom units vest over a four-yearperiod from the dates of issuance and distributions are held in trust by ourgeneral partner until such units vest.

 

The followingtable summarizes information about Hiland Partners’ phantom units for the ninemonths ended September 30, 2008:

 

| ** **                        | ** ** | ** ** | ** ** | **Weighted**        | ** ** | ** **                  | ** ** |
|-----------------------------------|------------|------------|------------|---------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Average**         | ** ** | ** **                  | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Fair Value** | ** ** | **Fair Value At** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **At Grant**   | ** ** | **Redemption**              | ** ** |
| ** **                        | ** ** | **Units**  | ** ** | **Date**            | ** ** | **Date**                    | ** ** |
| Unvested  January 1, 2008    |       | 42,825     |       | $                   | 50.12      |                        |       |   |
| Granted                           |       | 20,500     |       | $                   | 49.36      |                        |       |   |
| Vested and  converted             |       | (1,807     | )          | $                   | 54.50      |                        |       |   |
| Vested and  redeemed              |       | (693       | )          | $                   | 54.50      |                        | $          | 50.00 |   |
| Forfeited                         |       | (6,300     | )          | $                   | 48.80      |                        |       |   |
| Unvested  September 30, 2008 |       | 54,525     |       | $                   | 48.83      |                        |       |   |
|                                   |            |            |            |                     |            |                             |            |  |  |

 

During the threeand nine months ended September 30, 2008, Hiland Partners incurrednon-cash unit based compensation expense of $297 and $877, respectively,related to phantom units. During the three and nine months ended September 30,2007, Hiland Partners incurred non-cash unit based compensation expense of $73and $81, respectively, related to phantom units. Hiland Partners will recognizeadditional expense of $1,698 over the next four years, and the additionalexpense is to be recognized over a weighted average period of 2.9 years.

 

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*RestrictedUnits.*   As providedfor in Hiland Partners’ Long-Term Incentive Plan, each non-employee boardmember of its general partner on each anniversary date of the initial award isentitled to receive an additional 1,000 restricted common units.  Accordingly, Hiland Partners issued a totalof 6,000 restricted units to its six non-employee board members of its generalpartner during the three and nine months ended September 30, 2008. Also during the three months ended September 30, 2008, a total of 5,500restricted units issued to the six non-employee board members of its generalpartner in 2005, 2006 and 2007 vested and were converted into commonunits.  The following table summarizesinformation about Hiland Partners restricted units for the nine months ended September 30,2008.

 

| ** **                             | ** ** | ** ** | ** ** | **Weighted**        | ** ** |
|----------------------------------------|------------|------------|------------|---------------------|------------|
| ** **                             | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                             | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Restricted Units**              | ** ** | **Units**  | ** ** | **Date ($)**   | ** ** |
| Non-vested at  January 1, 2008    |       | 19,375     |       | $                   | 46.57      |   |
| Granted                                |       | 6,000      |       | $                   | 43.97      |   |
| Vested                                 |       | (5,500     | )          | $                   | 44.78      |   |
| Forfeited or  expired                  |       | (375       | )          | $                   | 48.85      |   |
| Non-vested at  September 30, 2008 |       | 19,500     |       | $                   | 46.23      |   |

 

Non-cash unitbased compensation expense related to Hiland Partners restricted units was $91and $258 for the three and nine months ended September 30, 2008,respectively, and was $137 and $377 for the three and nine months ended September 30,2007, respectively. As of September 30, 2008, there was $528 of totalunrecognized cost related to Hiland Partners unvested restricted units. Thiscost is to be recognized over a weighted average period of 2.7 years.

 

*UnitOptions.*   HilandPartners has not granted unit options since March 2006. In October 1995,The FASB issued SFAS No. 123, “Share-Based Payment,” which was revised in December 2004(collectively, “SFAS 123R”). As a result of adopting SFAS 123R on the modifiedprospective basis beginning on January 1, 2006, during the three and ninemonths ended September 30, 2008, Hiland Partners incurred non-cash unitbased compensation expense of $8 and $24, respectively, related to unit optionsthat were awarded in both 2006 and 2005. During the three and nine months endedSeptember 30, 2007, Hiland Partners expensed $34 and $131, respectively,related to the unit options.

 

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

 

| ** **                              | ** ** | ** ** | ** ** | ** **         | ** ** | **Weighted-**         | ** ** | ** **         | ** ** |
|-----------------------------------------|------------|------------|------------|--------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **Weighted**       | ** ** | **Average**           | ** ** | ** **         | ** ** |
| ** **                              | ** ** | ** ** | ** ** | **Average**        | ** ** | **Remaining**         | ** ** | **Aggregate**      | ** ** |
| ** **                              | ** ** | ** ** | ** ** | **Exercise**       | ** ** | **Contractual**       | ** ** | **Intrinsic**      | ** ** |
| **Options**                             | ** ** | **Units**  | ** ** | **Price ($)** | ** ** | **Term (Years)** | ** ** | **Value ($)** | ** ** |
| Outstanding at  January 1, 2008    |       | 75,041     |       | $                  | 28.24      |                  |       |               |       |   |
| Granted                                 |       | —     |       |               |       |                  |       |               |       |
| Exercised                               |       | (40,705    | )          | $                  | 25.32      |                  |       |               | $          | 975 |   |
| Forfeited or  expired                   |       | (1,000     | )          | $                  | 40.11      |                  |       |               |       |   |
| Outstanding at  September 30, 2008 |       | 33,336     |       | $                  | 37.92      |                  | 7.3        |               | —     |   |
| Exercisable at  September 30, 2008 |       | 24,002     |       | $                  | 37.01      |                  | 7.1        |               | —     |   |
|                                         |            |            |            |                    |            |                       |            |                    |            |  |  |

 

**Note 8: Commitments and Contingencies**

** **

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

 

We maintain a definedcontribution retirement plan for our employees under which we make discretionarycontributions to the plan based on a percentage of eligible employees’compensation. Contributions to the plan are 5.0% of eligible employees’compensation and resulted in expense for the three months ended September 30,2008 and 2007 of $85 and $65, respectively, and for the nine months ended September 30,2008 and 2007 was $240 and $193, respectively.

 

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

 

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

 

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

 

Hiland Partners leasescertain equipment, vehicles and facilities under operating leases, most ofwhich contain annual renewal options. We and Hiland Partners also lease officespace from a related entity. See Note 10 “Related Party Transactions.” Underthese lease agreements, rent expense was $731 and $532, respectively, for thethree months ended September 30, 2008 and 2007 and $1,983 and $1,541 forthe nine months ended September 30, 2008 and 2007, respectively.

 

**Note 9: Significant Customers and Suppliers**

 

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

 

| ** ** | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** ** | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** ** | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Customer 1 |       | 18                                      | %          | 7                                      | %          | 13 | % | 7 | % |
| Customer 2 |       | 14                                      | %          | 15                                     | %          | 10 | % | 12 | % |
| Customer 3 |       | 10                                      | %          | 9                                      | %          | 9 | % | 9 | % |
| Customer 4 |       | 7                                       | %          | 9                                      | %          | 12 | % | 20 | % |
| Customer 5 |       | 5                                       | %          | 19                                     | %          | 15 | % | 17 | % |

 

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

 

| ** **                       | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                       | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                       | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| Supplier 1  (affiliated company) |       | 45                                      | %          | 32                                     | %          | 42 | % | 29 | % |
| Supplier 2                       |       | 17                                      | %          | 25                                     | %          | 18 | % | 26 | % |
| Supplier 3                       |       | 14                                      | %          | 13                                     | %          | 15 | % | 14 | % |

 

**Note 10: Related Party Transactions**

 

Hiland Partners purchasesnatural gas and NGLs from affiliated companies. Purchases of product fromaffiliates totaled $36,279 and $14,522 for the three months ended September 30,2008 and 2007, respectively, and totaled $99,328 and $39,264  for the nine months ended September 30,2008 and 2007, respectively. Hiland Partners also sells natural gas and NGLs toaffiliated companies. Sales of product to affiliates totaled $7,390 and $654for the three months ended September 30, 2008 and 2007, respectively, andtotaled $10,433 and $2,390 for the nine months ended September 30, 2008and 2007, respectively. Compression revenues from affiliates were $1,205 and$3,615 for each of the three and nine months ended September 30, 2008 and2007, respectively.

 

Accountsreceivable-affiliates of $5,323 at September 30, 2008 include $5,183 fromone affiliate for midstream sales. Accounts receivable-affiliates of $1,178 at December 31,2007, includes $1,090 from one affiliate for midstream sales.

 

Accountspayable-affiliates of $8,437 at September 30, 2008 include $7,671 due toone affiliate for midstream purchases. Accounts payable-affiliates of $7,957 atDecember 31, 2007 include $7,094 payable to the same affiliate for midstreampurchases.

 

Hiland Partners utilizesaffiliated companies to provide services to its plants and pipelines andcertain administrative services. The total expenditures to these companies were$157 and $78 during the three months ended September 30, 2008 and 2007,respectively, and were $420 and $352 during the nine months ended September 30,2008 and 2007, respectively.

 

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We and Hiland Partnerslease office space under operating leases directly or indirectly from anaffiliate. Rent expense associated with these leases totaled $42 and $38 forthe three months ended September 30, 2008 and 2007, respectively, and totaled$117 and $105 for the nine months ended September 30, 2008 and 2007,respectively.

 

**Note 11: Reportable Segments**

** **

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

 

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

 

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

 

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

 

Midstream assets totaled$427,300 at September 30, 2008. Assets attributable to compressionoperations totaled $26,117. All but $63 of the total capital expenditures of$38,043 for the nine months ended September 30, 2008 was attributable tomidstream operations. All but $16 of the total capital expenditures of $73,318for the nine months ended September 30, 2007 was attributable to midstreamoperations.

 

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

 
| ** **                                                       | ** ** | **For the Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2008**                                                                   | ** ** | **2007** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                              | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Segment**                                                                | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
| ** **                                                       | ** ** | ** **                                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                         |       | $                                                                          | 114,548    |   | $ | 1,205 |   | $ | 115,753 |   | $ | 66,431 |   | $ | 1,205 |   | $ | 67,636 |   |
| Operating costs  and expenses:                                   |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 81,895                                                                     |       | — |   | 81,895 |   | 45,789 |   | — |   | 45,789 |   |
| Operations and  maintenance                                      |       | 7,617                                                                      |       | 264 |   | 7,881 |   | 5,913 |   | 244 |   | 6,157 |   |
| Depreciation and  amortization                                   |       | 8,946                                                                      |       | 896 |   | 9,842 |   | 6,975 |   | 895 |   | 7,870 |   |
| Bad debt                                                         |       | (7,799                                                                     | )          | — |   | (7,799 | ) | — |   | — |   | — |   |
| General and  administrative expenses                             |       | 2,570                                                                      |       | 27 |   | 2,597 |   | 2,017 |   | 37 |   | 2,054 |   |
| Total operating  costs and expenses                              |       | 93,229                                                                     |       | 1,187 |   | 94,416 |   | 60,694 |   | 1,176 |   | 61,870 |   |
| Operating income                                                 |       | $                                                                          | 21,319     |   | $ | 18 |   | 21,337 |   | $ | 5,737 |   | $ | 29 |   | 5,766 |   |
| Other income  (expense):                                         |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest and  other income                                       |       |                                                                       |       |   |   | 99 |   |   |   |   |   | 105 |   |
| Amortization of  deferred loan costs                             |       |                                                                       |       |   |   | (169 | ) |   |   |   |   | (136 | ) |
| Interest expense                                                 |       |                                                                       |       |   |   | (3,279 | ) |   |   |   |   | (3,133 | ) |
| Minority  interest in income of Hiland Partners, LP              |       |                                                                       |       |   |   | (6,800 | ) |   |   |   |   | (867 | ) |
| Net income                                                       |       |                                                                       |       |   |   | $ | 11,188 |   |   |   |   |   | $ | 1,735 |   |

 

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| ** **                                                       | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                       | ** ** | **2008**                                                                  | ** ** | **2007** | ** ** |
| ** **                                                       | ** ** | **Midstream**                                                             | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Segment**                                                               | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
| ** **                                                       | ** ** | ** **                                                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                         |       | $                                                                         | 319,058    |   | $ | 3,615 |   | $ | 322,673 |   | $ | 191,691 |   | $ | 3,615 |   | $ | 195,306 |   |
| Operating costs  and expenses:                                   |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Midstream  purchases (exclusive of items shown separately below) |       | 238,586                                                                   |       | — |   | 238,586 |   | 137,320 |   | — |   | 137,320 |   |
| Operations and  maintenance                                      |       | 21,428                                                                    |       | 773 |   | 22,201 |   | 15,499 |   | 609 |   | 16,108 |   |
| Depreciation and  amortization                                   |       | 25,827                                                                    |       | 2,686 |   | 28,513 |   | 19,539 |   | 2,683 |   | 22,222 |   |
| Bad debt                                                         |       | 304                                                                       |       | — |   | 304 |   | — |   | — |   | — |   |
| General and  administrative expenses                             |       | 7,529                                                                     |       | 86 |   | 7,615 |   | 6,265 |   | 118 |   | 6,383 |   |
| Total operating  costs and expenses                              |       | 293,674                                                                   |       | 3,545 |   | 297,219 |   | 178,623 |   | 3,410 |   | 182,033 |   |
| Operating income                                                 |       | $                                                                         | 25,384     |   | $ | 70 |   | 25,454 |   | $ | 13,068 |   | $ | 205 |   | 13,273 |   |
| Other income  (expense):                                         |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest and  other income                                       |       |                                                                      |       |   |   | 276 |   |   |   |   |   | 325 |   |
| Amortization of  deferred loan costs                             |       |                                                                      |       |   |   | (493 | ) |   |   |   |   | (357 | ) |
| Interest expense                                                 |       |                                                                      |       |   |   | (9,915 | ) |   |   |   |   | (7,538 | ) |
| Minority  interest in income of Hiland Partners, LP              |       |                                                                      |       |   |   | (4,402 | ) |   |   |   |   | (2,080 | ) |
| Net income                                                       |       |                                                                      |       |   |   | $ | 10,920 |   |   |   |   |   | $ | 3,623 |   |

** **

**Note 12: Net Income per Limited Partners’ Unit**

** **

The computation of basicnet income per limited partners’ unit is based on the weighted-average numberof common units outstanding during the period. The computation of dilutedearnings per unit further assumes the dilutive effect of restricted units. Netincome per unit applicable to limited partners is computed by dividing netincome applicable to limited partners by the weighted-average number of limitedpartnership units outstanding. The following is a reconciliation of the limitedpartner units used in the calculations of income per limited partner unit—basicand income per limited partner unit—diluted assuming dilution for the three andnine months ended September 30, 2008 and 2007:

 
| ** **                                                     | ** ** | **For the Three Months Ended September 30,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                                                   | ** ** | **2007** | ** ** |
| ** **                                                     | ** ** | **Income**                                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Income** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Available to**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Available to** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Limited**                                                                | ** ** | **Limited** | ** ** | ** ** | ** ** | **Limited** | ** ** | **Limited** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Partners**                                                               | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** | **Partners** | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                     | ** ** | **(Numerator)**                                                            | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Income per  limited partner unit -basic:                       |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Income available  to limited partners                          |       | $                                                                          | 11,188     |   |   |   | $ | 0.52 |   | $ | 1,735 |   |   |   | $ | 0.08 |   |
| Weighted average  limited partner units outstanding            |       |                                                                       |       | 21,603,000 |   |   |   |   |   | 21,600,000 |   |   |   |
| Income per  limited partner unit - diluted: Restricted units   |       |                                                                       |       | 9,000 |   |   |   |   |   | 9,000 |   |   |   |
| Income available  to limited partners plus assumed conversions |       | $                                                                          | 11,188     |   | 21,612,000 |   | $ | 0.52 |   | $ | 1,735 |   | 21,609,000 |   | $ | 0.08 |   |

 

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| ** **                                                     | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                                                  | ** ** | **2007** | ** ** |
| ** **                                                     | ** ** | **Income**                                                                | ** ** | ** ** | ** ** | ** ** | ** ** | **Income** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Available to**                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Available to** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Limited**                                                               | ** ** | **Limited** | ** ** | ** ** | ** ** | **Limited** | ** ** | **Limited** | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | **Partners**                                                              | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** | **Partners** | ** ** | **Partner Units** | ** ** | **Per Unit** | ** ** |
| ** **                                                     | ** ** | **(Numerator)**                                                           | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** | **(Numerator)** | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Income per limited  partner unit -basic:                       |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Income available  to limited partners                          |       | $                                                                         | 10,920     |   |   |   | $ | 0.51 |   | $ | 3,623 |   |   |   | $ | 0.17 |   |
| Weighted average  limited partner units outstanding            |       |                                                                      |       | 21,603,000 |   |   |   |   |   | 21,600,000 |   |   |   |
| Income per  limited partner unit - diluted: Restricted units   |       |                                                                      |       | 7,000 |   |   |   |   |   | 10,000 |   |   |   |
| Income available  to limited partners plus assumed conversions |       | $                                                                         | 10,920     |   | 21,610,000 |   | $ | 0.51 |   | $ | 3,623 |   | 21,610,000 |   | $ | 0.17 |   |

 

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

** **

***Hiland Holdings***

*** ***

Our unitholders (limitedpartners) have only limited voting rights on matters affecting our operationsand activities and, therefore, limited ability to influence our management’sdecisions regarding our business. Unitholders did not select our generalpartner or elect the board of directors of our general partner and effectivelyhave no right to select our general partner or elect its board of directors inthe future. Unitholders’ voting rights are further restricted by ourpartnership agreement, which provides that any units held by a person that owns20% or more of any class of units then outstanding, other than the generalpartner, its affiliates, their transferees and persons who acquired such unitswith the prior approval of the board of directors of our general partner,cannot be voted on any matter. In addition, our partnership agreement containsprovisions limiting the ability of our unitholders to call meetings or toacquire information about our operations, as well as other provisions limitinga unitholders’ ability to influence the manner or direction of our management.

 

Our partnership agreementrequires that we distribute all of our cash on hand at the end of each quarter,less reserves established at our general partner’s discretion. We refer to thisas “available cash.” Initially our only cash-generating assets are ourinterests in Hiland Partners from which we receive quarterly distributions. Theamount of available cash may be greater than or less than the minimum quarterlydistributions.

 

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

 

| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** **          | ** ** |
|--------------------|------------|-----------------------------|------------|---------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Distribution**    | ** ** |
| 02/19/07           |       | $                           | 0.2075     |                | $          | 4,484 |   |
| 05/18/07           |       | 0.2075                      |       | 4,484               |       |
| 08/17/07           |       | 0.2200                      |       | 4,755               |       |
| 11/19/07           |       | 0.2300                      |       | 4,972               |       |
| 02/19/08           |       | 0.2550                      |       | 5,513               |       |
| 05/19/08           |       | 0.2800                      |       | 6,053               |       |
| 08/19/08           |       | 0.3050                      |       | 6,594               |       |
| 11/13/08 (a)       |       | 0.3175                      |       | 6,866               |       |
|               |       | $                           | 2.0225     |                | $          | 43,721 |   |

 

----

(a)          Thiscash distribution was announced on October 24, 2008 and will be paid on November 19,2008 to all unitholders of record as of November 4, 2008.

 

***Hiland Partners***

*** ***

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

 

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

 

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

 

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

 

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

 

If cash distributions perunit exceed $0.495 in any quarter, Hiland Partners GP, LLC as general partnerwill receive increasing percentages, up to a maximum of 50% of the cash HilandPartners distributes in excess of that amount. Hiland Partners refers to thesedistributions as “incentive distributions.”

 

The distributions on thesubordinated units may be reduced or eliminated if necessary to ensure thecommon units receive their minimum quarterly distribution. Subordinated unitswill not accrue arrearages. The subordination period will end with respect tocertain portions of the subordinated units once Hiland Partners meets certainfinancial tests, but will not end with respect to all subordinated units beforeMarch 31, 2010. These financial tests require Hiland Partners to haveearned and paid the minimum quarterly distribution on all of its outstandingunits for three consecutive four-quarter periods. When the subordination periodends, all remaining subordinated units will convert into common units on aone-for-one basis and the common units will no longer be entitled toarrearages. Following Hiland Partners’ distribution on May 14, 2008, thesefinancial tests were met for the immediate preceding three consecutivefour-quarter periods, and accordingly, 25%, or 1,020,000, of the subordinatedunits were converted to common units on May 19, 2008.

 

Presented below are cashdistributions to Hiland Partners common and subordinated unitholders, includingamounts to affiliate owners and regular and incentive distributions to HilandPartners GP, LLC paid by Hiland Partners from January 1, 2007 forward (inthousands, except per unit amounts):

 

| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       | ** ** |
|--------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|------------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** | ** ** |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** | ** ** |
| 02/14/07           |       | $                           | 0.7125     |       | $          | 3,694            |       | $                        | 2,907      |                | $          | 150              |       | $ | 749 |   | $ | 7,500 |   |
| 05/15/07           |       | 0.7125                      |       | 3,724      |       | 2,907            |       | 151                      |       | 752                 |       | 7,534            |       |
| 08/14/07           |       | 0.7325                      |       | 3,837      |       | 2,989            |       | 158                      |       | 932                 |       | 7,916            |       |
| 11/14/07           |       | 0.7550                      |       | 3,959      |       | 3,080            |       | 167                      |       | 1,134               |       | 8,340            |       |
| 02/14/08           |       | 0.7950                      |       | 4,169      |       | 3,243            |       | 182                      |       | 1,492               |       | 9,086            |       |
| 05/14/08           |       | 0.8275                      |       | 4,364      |       | 3,376            |       | 194                      |       | 1,789               |       | 9,723            |       |
| 08/14/08           |       | 0.8625                      |       | 5,444      |       | 2,640            |       | 208                      |       | 2,107               |       | 10,399           |       |
| 11/14/08 (a)       |       | 0.8800                      |       | 5,574      |       | 2,693            |       | 215                      |       | 2,268               |       | 10,750           |       |
|               |       | $                           | 6.2775     |       | $          | 34,765           |       | $                        | 23,835     |                | $          | 1,425            |       | $ | 11,223 |   | $ | 71,248 |   |

 

----

(a)          Thiscash distribution was announced on October 24, 2008 and will be paid on November 14,2008 to all unitholders of record as of November 4, 2008.

 

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

 
| **Date Cash** | ** ** | **Per Unit Cash** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **               | ** ** | ** **          | ** ** | ** **       |   |
|--------------------|------------|-----------------------------|------------|------------|------------|------------------|------------|--------------------------|------------|---------------------|------------|------------------|--------|
| **Distribution**   | ** ** | **Distribution**            | ** ** | **Common** | ** ** | **Subordinated** | ** ** | **General Partner** | ** ** | **Total Cash** |       |
| **Paid**           | ** ** | **Amount**                  | ** ** | **Units**  | ** ** | **Units**        | ** ** | **Regular**              | ** ** | **Incentive**       | ** ** | **Distribution** |   |
| 02/14/07           |       | $                           | 0.7125     |       | $          | 927              |       | $                        | 2,907      |                | $          | 150              |   | $ | 749 |   | $ | 4,733 |   |
| 05/15/07           |       | 0.7125                      |       | 927        |       | 2,907            |       | 151                      |       | 752                 |       | 4,737            |   |
| 08/14/07           |       | 0.7325                      |       | 953        |       | 2,989            |       | 158                      |       | 932                 |       | 5,032            |   |
| 11/14/07           |       | 0.7550                      |       | 983        |       | 3,080            |       | 167                      |       | 1,134               |       | 5,364            |   |
| 02/14/08           |       | 0.7950                      |       | 1,035      |       | 3,243            |       | 182                      |       | 1,492               |       | 5,952            |   |
| 05/14/08           |       | 0.8275                      |       | 1,077      |       | 3,376            |       | 194                      |       | 1,789               |       | 6,436            |   |
| 08/14/08           |       | 0.8625                      |       | 2,002      |       | 2,640            |       | 208                      |       | 2,107               |       | 6,957            |   |
| 11/13/08 (a)       |       | 0.8800                      |       | 2,043      |       | 2,693            |       | 215                      |       | 2,268               |       | 7,219            |   |
|               |       | $                           | 6.2775     |       | $          | 9,947            |       | $                        | 23,835     |                | $          | 1,425            |   | $ | 11,223 |   | $ | 46,430 |   |

 

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----

(a)          Thiscash distribution was announced on October 24, 2008 and will be paid on November 14,2008 to all unitholders of record as of November 4, 2008.

 

**Note14:   Supplemental Information**

 

Following are thefinancial statements of Hiland Holdings which are included to provideadditional information with respect to the Hiland Holdings’ financial position, results of operations and cashflows on a stand-alone basis.

 

**BALANCE SHEETS**

**(inthousands, except unit amounts)**

 

| ** **                                                                                                                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                        | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                        | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                        |       |                   |       |                  |       |
| **Current  assets:**                                                                                                                              |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                        |       | $                      | 442        |                  | $          | 105 |   |
| Accounts  receivable-affiliates                                                                                                                   |       | 3                      |       | 6                     |       |
| Other current  assets                                                                                                                             |       | 128                    |       | 265                   |       |
| Total current  assets                                                                                                                             |       | 573                    |       | 376                   |       |
|                                                                                                                                              |       |                   |       |                  |       |
| Investment in  subsidiary                                                                                                                         |       | 9,924                  |       | 16,183                |       |
| Property and  equipment, net                                                                                                                      |       | 3,416                  |       | 3,753                 |       |
| Intangibles, net                                                                                                                                  |       | 5,312                  |       | 5,835                 |       |
| Other assets,  net                                                                                                                                |       | 89                     |       | 155                   |       |
| **Total  assets**                                                                                                                                 |       | $                      | 19,314     |                  | $          | 26,302 |   |
|                                                                                                                                              |       |                   |       |                  |       |
| **LIABILITIES  AND PARTNERS’ EQUITY**                                                                                                        | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Current  liabilities:**                                                                                                                         |       |                   |       |                  |       |
| Accounts payable                                                                                                                                  |       | $                      | 48         |                  | $          | 4 |   |
| Accounts payable-affiliates                                                                                                                       |       | 126                    |       | 383                   |       |
| Other current  liabilities                                                                                                                        |       | 705                    |       | —                |       |
| Total current  liabilities                                                                                                                        |       | 879                    |       | 387                   |       |
|                                                                                                                                              |       |                   |       |                  |       |
| Long-term debt,  net of current maturities                                                                                                        |       | —                 |       | 355                   |       |
|                                                                                                                                              |       |                   |       |                  |       |
| **Partners’  equity**                                                                                                                        |       |                   |       |                  |       |
| Common  unitholders (21,607,500 and 21,603,000 units issued and outstanding at  September 30, 2008 and December 31, 2007, respectively) |       | 18,435                 |       | 25,560                |       |
| **Total  partners’ equity**                                                                                                                  |       | 18,435                 |       | 25,560                |       |
|                                                                                                                                              |       |                   |       |                  |       |
| **Total  liabilities and partners’ equity**                                                                                                  |       | $                      | 19,314     |                  | $          | 26,302 |   |

 

24

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**STATEMENTSOF OPERATIONS**

**(inthousands, unaudited)**

 
| ** **                           | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Operating  costs and expenses:**   |       |                                                     |       |                                                    |       |   |   |   |   |
| Depreciation and  amortization       |       | $                                                        | (287       | )                                                       | $          | (287 | ) | $ | (861 | ) | $ | (860 | ) |
| General and  administrative expenses |       | (339                                                     | )          | (339                                                    | )          | (1,192 | ) | (1,275 | ) |
| Operating loss                       |       | (626                                                     | )          | (626                                                    | )          | (2,053 | ) | (2,135 | ) |
| **Other  income (expense):**         |       |                                                     |       |                                                    |       |   |   |   |   |
| Equity in  earnings of affiliates    |       | 11,841                                                   |       | 2,387                                                   |       | 13,058 |   | 5,833 |   |
| Interest and  other income           |       | 3                                                        |       | 3                                                       |       | 9 |   | 11 |   |
| Amortization of  deferred loan costs |       | (22                                                      | )          | (22                                                     | )          | (67 | ) | (67 | ) |
| Interest expense                     |       | (8                                                       | )          | (7                                                      | )          | (27 | ) | (19 | ) |
| Other income  (expense), net         |       | 11,814                                                   |       | 2,361                                                   |       | 12,973 |   | 5,757 |   |
| **Net  income**                      |       | $                                                        | 11,188     |                                                    | $          | 1,735 |   | $ | 10,920 |   | $ | 3,623 |   |

 

**STATEMENTSOF CASH FLOWS**

**Forthe Nine Months Ended (unaudited)**

 
| ** **                                                                                   | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                   | ** ** | **2008**                | ** ** | **2007**               | ** ** |
| ** **                                                                                   | ** ** | **(in thousands)** | ** ** |
| **Cash  flows from operating activities:**                                                   |       |                    |       |                   |       |
| Net income                                                                                   |       | $                       | 10,920     |                   | $          | 3,623 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                    |       |                   |       |
| Depreciation and  amortization                                                               |       | 861                     |       | 860                    |       |
| Amortization of  deferred loan cost                                                          |       | 67                      |       | 67                     |       |
| Unit based  compensation                                                                     |       | 115                     |       | 444                    |       |
| Earnings in  Hiland Partners, LP                                                             |       | (13,058                 | )          | (5,833                 | )          |
| (Increase)  decrease in current assets:                                                      |       |                    |       |                   |       |
| Accounts  receivable - affiliates                                                            |       | 3                       |       | (6                     | )          |
| Other current  assets                                                                        |       | 137                     |       | (27                    | )          |
| Increase  (decrease) in current liabilities:                                                 |       |                    |       |                   |       |
| Accounts payable  - trade                                                                    |       | 44                      |       | (104                   | )          |
| Accounts payable  - affiliates                                                               |       | (258                    | )          | 63                     |       |
| Accrued  liabilities and other                                                               |       | —                  |       | (39                    | )          |
| **Net  cash provided by (used in) operating activities**                                     |       | (1,169                  | )          | (952                   | )          |
| **Cash  flows from investing activities:**                                                   |       |                    |       |                   |       |
| Investment in  subsidiaries                                                                  |       | (28                     | )          | (27                    | )          |
| Cash  distributions received from subsidiaries                                               |       | 19,345                  |       | 14,503                 |       |
| **Net  cash provided by (used in) investing activities**                                     |       | 19,317                  |       | 14,476                 |       |
| **Cash  flows from financing activities:**                                                   |       |                    |       |                   |       |
| Proceeds from  long-term borrowings                                                          |       | 350                     |       | 100                    |       |
| Debt issuance  costs                                                                         |       | (1                      | )          | —                 |       |
| Cash  distributions to unitholders                                                           |       | (18,160                 | )          | (13,724                | )          |
| **Net  cash provided by (used in) financing activities**                                     |       | (17,811                 | )          | (13,624                | )          |
|                                                                                         |       |                    |       |                   |       |
| Increase  (decrease) for the period                                                          |       | 337                     |       | (100                   | )          |
| Beginning of  period                                                                         |       | 105                     |       | 183                    |       |
| **End of  period**                                                                           |       | $                       | 442        |                   | $          | 83 |   |

 

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**Note15:   Subsequent Event**

 

On July 22, 2008, SemGroup, L.P. and certain subsidiariesfiled voluntary petitions for reorganization under Chapter 11 of the U.S.Bankruptcy Code.  Affiliates of SemGroup,L.P. purchase Hiland Partners natural gas liquids and condensate, primarily attheir Bakken and Badlands plants and gathering systems.  During the second quarter 2008, HilandPartners increased their allowance for doubtful accounts and bad debt expenseby $8.1 million for related product sales through June 30, 2008. On October 20,2008, the United States Bankruptcy Court for the District of Delaware enteredan order approving the assumption of a Natural Gas Liquids Marketing Agreement(the “SemStream Agreement”) between SemStream, L.P., an affiliate of SemGroup,L.P., and Hiland Partners relating to the sale of natural gas liquids andcondensate at our Bakken and Badlands plants and gathering systems. As a resultof the assumption, and in accordance with the order, on October 21, 2008,SemStream paid $12.1 million to Hiland Partners, representing amounts owed toHiland Partners from SemStream for June and July 2008 product salesunder the SemStream Agreement. The assumption of the SemStream Agreementrestores Hiland Partners and SemStream, L.P. to their pre-bankruptcycontractual relationship.

 

HilandPartners’ third quarter results of operations reflect a reversal of $7.8million of the $8.1 million allowance for doubtful accounts and bad debtexpense previously recorded on their income statement in the second quarter of2008. After receipt of the October 21 payment, Hiland Partners’ totalpre-petition credit exposure to SemGroup, related to condensate sales toSemCrude, LLC, and outside of the SemStream Agreement, is approximately $0.3million, which Hiland Partners’ has reserved as of September 30, 2008.

 

On October 7, 2008,Hiland Partners entered into a floating-to-fixedinterest rate swap agreement with an investment grade counterpartywhereby they pay a monthly fixed interest rate of 2.245% and receive a monthlyvariable rate based on the one month posted LIBOR interest rate on a notionalamount of $100.0 million.  This swapagreement is effective on January 2, 2009 and terminates on January 1,2010.

 

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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.

 

Our 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 pay distributions toour unitholders;

 

·         our expected receipt of distributionsfrom Hiland Partners;

 

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

 

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

 

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

 

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

 

·         thefees Hiland Partners charges and the margins realized for its services;

 

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

 

·         energyprices generally;

 

·         thelevel of domestic oil and natural gas production;

 

·         theavailability of imported oil and natural gas;

 

·         actionstaken by foreign oil and gas producing nations;

 

·         thepolitical and economic stability of petroleum producing nations;

 

·         theweather in Hiland Partners’ operating areas;

 

·         theextent of governmental regulation and taxation;

 

·         hazardsor operating risks incidental to the transporting, treating and processing ofnatural gas and NGLs that may not be fully covered by insurance;

 

·         competitionfrom other midstream companies;

 

·         lossof key personnel;

 

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

 

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

 

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

 

·         thecosts and effects of legal and administrative proceedings;

 

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

 

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

 

·                  because of the natural decline in production from existing wells, oursuccess depends on Hiland Partners’ ability to obtain new supplies of naturalgas, which involves factors beyond its control. Any decrease in supplies of natural gas in Hiland Partners’ areas ofoperation could adversely affect Hiland Partners’ business and operatingresults;

 

·                  the completion of significant,unbudgeted expansion projects may require debt and/or equity financing whichmay not be available to Hiland Partners on acceptable terms, or at all; 

 

·                  increases in interest rates could increase Hiland Partners’ borrowingcosts, adversely impact its unit price and its ability to issue additionalequity, which could have an adverse effect on Hiland Partners’ cash flows andits ability to fund its growth; and

 

·      Hiland Partners’ cash flowis affected by the volatility of natural gas and NGL product prices, whichcould adversely affect its ability to make distributions to us.

 

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 variousother risks and uncertainties, including, but not limited to those describedabove. Other unknown or unpredictable factors also could have material adverseeffects on 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 of Financial Condition and Results ofOperations**

 

Unless the context requires otherwise, references to “we”,“our,” “us,” “Hiland Holdings” or “the Partnership” are intended to mean theconsolidated business 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.

 

**Disruption to functioning of capitalmarkets**

 

Multiple events during 2008 involving numerousfinancial institutions have effectively restricted current liquidity within thecapital markets throughout the United States and around the world. Despiteefforts by treasury and banking regulators in the United States, Europe andother nations around the world to provide liquidity to the financial sector,capital markets currently remain constrained. We expect that ours and HilandPartners’ ability to raise debt and equity at prices that are similar toofferings in recent years to be limited over the next three to six months andpossibly longer should capital markets remain constrained.

 

In the weeks following the third quarter, our unitprice declined to a closing low of $8.41 on October 10, 2008. Since thatdate our unit price recovered partially to a level of $[ · ] onNovember 7, 2008. Hiland Partners currently intends to move forward withits planned internal growth projects, and in the near-term Hiland Partners willfocus on maintaining sufficient liquidity to fund its growth programs, see “Liquidityand Capital Resources.” Maintaining adequate liquidity may involve the issuanceof debt and/or equity at less attractive terms.

 

**Overviewof 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 ourownership interest in Hiland Partners on a consolidated basis, which means thatour financial results are combined with Hiland Partners’ financial results. Thenon-controlling limited partner interest in Hiland Partners is reflected as anexpense in our results of operations and as a liability on our consolidatedbalance sheet. Hiland Partners GP, LLC’s results of operations principallyreflect the results of operations of Hiland Partners and are adjusted fornon-controlling partners’ interests in Hiland Partners’ net income.

 

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 natural gas liquidsand providing air compression and water injection services for oil and gassecondary recovery operations. Our aggregate ownership interests in HilandPartners consist of the following:

 

·         the 2% general partner interest inHiland Partners;

 

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

 

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·         2,321,471 common units and 3,060,000subordinated units of Hiland Partners, representing a 57.5% limited partnerinterest 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. Hiland Partners announced its quarterly distribution of$0.88 per unit for the quarter ended September 30, 2008. This distributionwill be paid on November 14, 2008 to unitholders of record on November 4,2008.

 

Our primary objective is to increase our cash distributions to ourunitholders by actively assisting Hiland Partners in executing its businessstrategy. We intend to support Hiland Partners in implementing its businessstrategy by assisting in identifying, evaluating and pursuing growthopportunities. In the future, it is possible that we may also support thegrowth of Hiland Partners through the use of our capital resources, which couldinvolve loans or capital contributions to Hiland Partners to provide fundingfor the acquisition of a business or an asset or for an internal growthproject. In addition, we may provide Hiland Partners with other forms of creditsupport, such as guarantees relating to financing a project or other types ofsupport related to a merger or acquisition transaction.

 

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

 

| ** **                                                   | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Hiland Partner’s Distributions**            | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Common units                                            |       | $                                                        | 2,002      |                                                    | $          | 953 |   | $ | 4,114 |   | $ | 2,808 |   |
| Subordinated units                                           |       | 2,640                                                    |       | 2,989                                                   |       | 9,259 |   | 8,803 |   |
| Ownership interest in Hiland Partners’ general  partner |       | 208                                                      |       | 158                                                     |       | 584 |   | 459 |   |
| General partners’ incentive distribution rights         |       | 2,107                                                    |       | 932                                                     |       | 5,388 |   | 2,433 |   |
|                                                         |       | $                                                        | 6,957      |                                                    | $          | 5,032 |   | $ | 19,345 |   | $ | 14,503 |   |

 

Because we own Hiland Partners GP, LLC, thedistributions to us include the 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 inpurchasing, gathering, compressing, dehydrating, treating, processing andmarketing of natural gas and the fractionating and marketing of NGLs. Themidstream segment generated 96.4% and 94.5% of total segment margin for thethree months ended September 30, 2008 and 2007, respectively, and 95.7%and 93.8% of total segment margin for the nine months ended September 30,2008 and 2007, respectively.

 

·    *Compression Segment,* which is engaged inproviding air compression and water injection services for oil and gassecondary recovery operations that are ongoing in North Dakota. The compressionsegment generated 3.6% and 5.5% of total segment margin for the three monthsended September 30, 2008 and 2007, respectively, and 4.3% and 6.2% oftotal segment margin for the nine months ended September 30, 2008 and2007, respectively.

 

Hiland Partners’ midstream assets currently consist of 14 natural gasgathering systems with approximately 2,087 miles of gas gatheringpipelines, five 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

 

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increases or decreases inits profitability. Hiland Partners’ profitability is also dependent upon pricesand market demand for natural gas and NGLs, which fluctuate with changes inmarket and economic conditions and other factors.

 

**Recent Events**

 

*Hiland Partners DistributionIncrease.  *On October 24,2008, Hiland Partners declared a cash distribution for the third quarter of2008. This declared quarterlydistribution on its common and subordinated units increased to $0.88 per unit(an annualized rate of $3.52 per unit) from its most recent distribution of$0.8625 per unit (an annualized rate of $3.45 per unit). This represents a 2.0%increase over the prior quarter and a 16.6% increase over the distribution forthe same quarter of the prior year. The distribution will be paid on November 14,2008 to unitholders of record on November 4, 2008. Under Hiland Partners’partnership agreement, generally, its general partner is entitled to 15% of theamount it distributes to each unitholder in excess of $0.495 per unit perquarter up to $0.5625 per unit per quarter, 25% of the amount it distributes toeach unitholder in excess of $0.5625 per unit per quarter up to $0.675 per unitper quarter and 50% of the excess over $0.675 per unit per quarter.

 

*Our Distribution Increase.  *On October 24, 2008,we declared a cash distribution for the third quarter of 2008. This declaredquarterly distribution on our commonunits increased to $0.3175 per unit (an annualized rate of $1.27 per unit) fromour most recent distribution of $0.305 per unit (an annualized rate of $1.22per unit). This represents a 4.1% increase over the prior quarter and a 38.0%increase over the distribution for the same quarter of the prior year. Thedistribution will be paid on November 19, 2008 to unitholders of record onNovember 4, 2008.

 

*Significant Trade Account Receivable*. On July 22, 2008, SemGroup, L.P. and certain subsidiaries filedvoluntary petitions for reorganization under Chapter 11 of the U.S. BankruptcyCode.  Affiliates of SemGroup, L.P.purchase Hiland Partners’ natural gas liquids and condensate, primarily at itsBakken and Badlands plants and gathering systems.  During the second quarter 2008, HilandPartners increased its allowance for doubtful accounts and bad debt expense by$8.1 million for related  product salesthrough June 30, 2008. On October 20, 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 itsBakken and Badlands plants and gathering systems. As a result of theassumption, and in accordance with the order, on October 21, 2008,SemStream paid $12.1 million to Hiland Partners, representing amounts owed tothem from SemStream for June and July 2008 product sales under theSemStream Agreement. The assumption of the SemStream Agreement restores HilandPartners and SemStream, L.P. to its pre-bankruptcy contractual relationship.

 

Third quarter results of operations reflect areversal of $7.8 million of the $8.1 million allowance for doubtful accountsand bad debt expense previously recorded on the statement of operations in thesecond quarter of 2008. After receipt of the October 21 payment, HilandPartners’ total pre-petition credit exposure to SemGroup, related to condensatesales to SemCrude, LLC, and outside of the SemStream Agreement, is approximately$0.3 million, which Hiland Partners’ has reserved as of September 30,2008.

 

*Financial Hedge Agreement. *On October 7, 2008,Hiland Partners entered into a floating-to-fixedinterest rate swap agreement with an investment grade counterparty wherebyHiland Partners pays a monthly fixed interest rate of 2.245% and receives amonthly variable rate based on the one month posted LIBOR interest rate on anotional amount of $100.0 million.  Theswap agreement is effective January 2, 2009 and terminates on January 1,2010.

 

*Organic Growth Projects.*During the second quarter 2008, Hiland Partners entered into an agreement withCLR to construct and operate gathering pipelines, processing plants and relatedfacilities in the Bakken Shale play in northwestern North Dakota in which CLRhas dedicated approximately 129,000 gross acres to Hiland Partners. The initialterm of the agreement is for 10 years and grants Hiland Partners the right toprocess natural gas, share in the sales proceeds of the natural gas liquids andresidue gas and receive certain fixed fees for treating the natural gas. HilandPartners plans to make an initial capital investment of approximately $10.0million by the end of 2008 with additional investments of up to $17.0 millionover the next three years to build processing and treating facilities andinstall field gathering, compression and associated equipment.  As of September 30, 2008, HilandPartners has initially invested $0.4 million in the project. The expectedstartup of the initial phase of the project should occur no later than thesecond quarter of 2009.

 

During the third quarter of 2008, Hiland Partnersinvested approximately $10.4 million to expand the Woodford Shale gatheringsystem’s throughput capacity to approximately 65,000 Mcf/d.

 

**HistoricalResults of Operations**

 

Our historical results of operations for the periods presented may notbe comparable, either from period to period or going forward due to increasedvolumes and associated operating expenses at Hiland Partners’ Badlandsgathering system as a result of the

 

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construction of HilandPartners’ nitrogen rejection plant which became operational in August 2007and volumes and operating expenses at Hiland Partners’ Woodford Shale gatheringsystem which commenced operation in April 2007.

 

**OurResults of Operations**

 

The results of our operations discussed below principally reflect the activitiesof Hiland Partners. Because our consolidated financial statements include theresults of Hiland Partners, our financial statements are substantially similarto the financial statements of Hiland Partners. However, our consolidatedbalance sheet includes a minority interest amount that reflects the proportionof Hiland Partners owned by its unitholders other than us. Similarly, theownership interests in Hiland Partners held by its unitholders other than usare reflected in our consolidated income statement as minority interest. Theminority interest amounts are not reflected on Hiland Partners’ financialstatements.

 

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

 

| ** **                                                        | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **(in thousands)**                                  | ** ** |
| **Total Segment Margin Data:**                                    |       |                                                     |       |   |   |
| Midstream revenues                                                |       | $                                                        | 114,548    |   | $ | 66,431 |   |
| Midstream purchases                                               |       | 81,895                                                   |       | 45,789 |   |
| Midstream segment margin                                          |       | 32,653                                                   |       | 20,642 |   |
| Compression revenues (1)                                          |       | 1,205                                                    |       | 1,205 |   |
| Total segment margin (2)                                          |       | $                                                        | 33,858     |   | $ | 21,847 |   |
|                                                              |       |                                                     |       |   |   |
| **Summary of Operations Data:**                                   |       |                                                     |       |   |   |
| Midstream revenues                                                |       | $                                                        | 114,548    |   | $ | 66,431 |   |
| Compression revenues                                              |       | 1,205                                                    |       | 1,205 |   |
| Total revenues                                                    |       | 115,753                                                  |       | 67,636 |   |
|                                                              |       |                                                     |       |   |   |
| Midstream purchases (exclusive of items shown separately  below)  |       | 81,895                                                   |       | 45,789 |   |
| Operations and maintenance                                        |       | 7,881                                                    |       | 6,157 |   |
| Depreciation, amortization and accretion                          |       | 9,842                                                    |       | 7,870 |   |
| Bad debt                                                          |       | (7,799                                                   | )          | — |   |
| General and administrative                                        |       | 2,597                                                    |       | 2,054 |   |
| Total operating costs and expenses                                |       | 94,416                                                   |       | 61,870 |   |
| Operating income                                                  |       | 21,337                                                   |       | 5,766 |   |
| Other income (expense), net                                       |       | (3,349                                                   | )          | (3,164 | ) |
| Income before minority interest in income of Hiland  Partners, LP |       | 17,988                                                   |       | 2,602 |   |
| Minority interest in income of Hiland Partners, LP                |       | (6,800                                                   | )          | (867 | ) |
| **Net income**                                                    |       | $                                                        | 11,188     |   | $ | 1,735 |   |
|                                                              |       |                                                     |       |   |   |
| **Hiland Partners Operating Data:**                               |       |                                                     |       |   |   |
| Inlet natural gas (MCF/d)                                         |       | 261,345                                                  |       | 219,544 |   |
| Natural gas sales (MMBTU/d)                                       |       | 95,889                                                   |       | 84,281 |   |
| NGL sales (Bbls/d)                                                |       | 6,036                                                    |       | 4,721 |   |

 

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| ** **                                                        | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                                                        | ** ** | **(in thousands)**                                 | ** ** |
| **Total Segment Margin Data:**                                    |       |                                                    |       |   |   |
| Midstream revenues                                                |       | $                                                       | 319,058    |   | $ | 191,691 |   |
| Midstream purchases                                               |       | 238,586                                                 |       | 137,320 |   |
| Midstream segment margin                                          |       | 80,472                                                  |       | 54,371 |   |
| Compression revenues (1)                                          |       | 3,615                                                   |       | 3,615 |   |
| Total segment margin (2)                                          |       | $                                                       | 84,087     |   | $ | 57,986 |   |
|                                                              |       |                                                    |       |   |   |
| **Summary of Operations Data:**                                   |       |                                                    |       |   |   |
| Midstream revenues                                                |       | $                                                       | 319,058    |   | $ | 191,691 |   |
| Compression revenues                                              |       | 3,615                                                   |       | 3,615 |   |
| Total revenues                                                    |       | 322,673                                                 |       | 195,306 |   |
|                                                              |       |                                                    |       |   |   |
| Midstream purchases (exclusive of items shown  separately below)  |       | 238,586                                                 |       | 137,320 |   |
| Operations and maintenance                                        |       | 22,201                                                  |       | 16,108 |   |
| Depreciation, amortization and accretion                          |       | 28,513                                                  |       | 22,222 |   |
| Bad debt                                                          |       | 304                                                     |       | — |   |
| General and administrative                                        |       | 7,615                                                   |       | 6,383 |   |
| Total operating costs and expenses                                |       | 297,219                                                 |       | 182,033 |   |
| Operating income                                                  |       | 25,454                                                  |       | 13,273 |   |
| Other income (expense), net                                       |       | (10,132                                                 | )          | (7,570 | ) |
| Income before minority interest in income of Hiland  Partners, LP |       | 15,322                                                  |       | 5,703 |   |
| Minority interest in income of Hiland Partners, LP                |       | (4,402                                                  | )          | (2,080 | ) |
| **Net income**                                                    |       | $                                                       | 10,920     |   | $ | 3,623 |   |
|                                                              |       |                                                    |       |   |   |
| **Hiland Partners Operating Data:**                               |       |                                                    |       |   |   |
| Inlet natural gas (MCF/d)                                         |       | 245,098                                                 |       | 210,878 |   |
| Natural gas sales (MMBTU/d)                                       |       | 89,615                                                  |       | 78,998 |   |
| NGL sales (Bbls/d)                                                |       | 5,763                                                   |       | 4,340 |   |

 

----

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

 

(2) Reconciliationof total segment margin to operating income:

 

| ** **                                                      | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| ** **                                                      | ** ** | **(in thousands)**                                  | ** ** |
| **Reconciliation of Total Segment Margin to  Operating Income** |       |                                                     |       |   |   |
| Operating income                                                |       | $                                                        | 21,337     |   | $ | 5,766 |   |
| Add:                                                            |       |                                                     |       |   |   |
| Operations and maintenance expenses                             |       | 7,881                                                    |       | 6,157 |   |
| Depreciation, amortization and accretion                        |       | 9,842                                                    |       | 7,870 |   |
| Bad debt                                                        |       | (7,799                                                   | )          | — |   |
| General and administrative expenses                             |       | 2,597                                                    |       | 2,054 |   |
| Total segment margin                                            |       | $                                                        | 33,858     |   | $ | 21,847 |   |

 

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| ** **                                                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                                                      | ** ** | **(in thousands)**                                 | ** ** |
| **Reconciliation of Total Segment Margin to  Operating Income** |       |                                                    |       |   |   |
| Operating income                                                |       | $                                                       | 25,454     |   | $ | 13,273 |   |
| Add:                                                            |       |                                                    |       |   |   |
| Operations and maintenance expenses                             |       | 22,201                                                  |       | 16,108 |   |
| Depreciation, amortization and accretion                        |       | 28,513                                                  |       | 22,222 |   |
| Bad debt                                                        |       | 304                                                     |       | — |   |
| General and administrative expenses                             |       | 7,615                                                   |       | 6,383 |   |
| Total segment margin                                            |       | $                                                       | 84,087     |   | $ | 57,986 |   |

 

We view total segment margin, a non-GAAP financialmeasure, as an important performance measure of the core profitability of ouroperations because it is directly related to our volumes and commodity pricechanges. We review total segment margin monthly for a consistency and trendanalysis. We define midstream segment margin as midstream revenue lessmidstream purchases. Midstream purchases include the following costs andexpenses: cost of natural gas and NGLs purchased by us from third parties, costof natural gas and NGLs purchased by us from affiliates, and the cost of crudeoil purchased by us from third parties. We define compression segment margin asthe revenue derived from our compression segment. Our total segment margin maynot be comparable to similarly titled measures of other companies as othercompanies may not calculate total segment margin in the same manner.

 

**ThreeMonths Ended September 30, 2008 Compared with Three Months Ended September 30,2007**

 

***Revenues.*** Total revenues (midstream and compression) were $115.7 million for the threemonths ended September 30, 2008 compared to $67.6 million for the threemonths ended September 30, 2007, an increase of $48.1 million, or 71.1%. This $48.1 million increase was primarily due to: (i) increased naturalgas sales volumes of 15,830 MMBtu/day (MMBtu per day) and increased NGL salesvolumes of 609 Bbls/day (Bbls per day) related to the Woodford Shale gatheringsystem, (ii) increased NGL sales volumes of 646 Bbls/day attributable tothe expanded Badlands gathering system, including the nitrogen rejection plant,which commenced operation in August 2007 and (iii) significantlyhigher average realized natural gas and NGL sales prices for the three monthsended September 30, 2008 as compared to the same period in 2007, resultingin increased revenues for nearly all of the gathering systems.  Revenuesfrom compression assets were the same for both periods.

 

Midstream revenues were $114.5 million for the three months ended September 30,2008 compared to $66.4 million for the three months ended September 30,2007, an increase of $48.1 million, or 72.4%. Of this $48.1 million increase inmidstream revenues, approximately $13.3 million was attributable to revenuesfrom increased natural gas and NGL sales volumes at the Woodford Shale,Badlands, Bakken and Matli gathering systems and approximately $34.8 millionwas attributable to significantly higher average realized natural gas and NGLsales prices for the three months ended September 30, 2008 as compared tothe same period in 2007, resulting in increased revenues for all of thegathering systems.

 

Inlet natural gas was 261,345 Mcf/d (Mcf per day) for the three monthsended September 30, 2008 compared to 219,544 Mcf/d for the three monthsended September 30, 2007, an increase of 41,801 Mcf/d, or 19.0%.  This increase is primarily attributable tovolume growth at the Woodford Shale and Badlands gathering systems offset byvolume declines at the Eagle Chief and Worland gathering systems.

 

Natural gas sales volumes were 95,889 MMBtu/d for the three monthsended September 30, 2008 compared to 84,281 MMBtu/d for the three monthsended September 30, 2007, an increase of 11,608 MMBtu/d, or 13.8%. This 11,608 MMBtu/d net increase in natural gas sales volumes was attributableto increased natural gas sales volumes at the Woodford Shale, Bakken and Matligathering systems offset by reduced natural gas sales volumes at the EagleChief, Worland and Kinta gathering systems.

 

NGL sales volumes were 6,036 Bbls/d for the three months ended September 30,2008 compared to 4,721 Bbls/d for the three months ended September 30,2007, an increase of 1,315 Bbls/d, or 27.9%.  This net increase isprimarily attributable to volume growth at the Woodford Shale and Badlandsgathering systems.

 

Average realized natural gas sales prices were $7.57 per MMBtu for thethree months ended September 30, 2008 compared to $5.20 per MMBtu for thethree months ended September 30, 2007, an increase of $2.37 per MMBtu, or45.6%.  Average realized NGL sales prices were $1.55 per gallon for thethree months ended September 30, 2008 compared to $1.16 per gallon for thethree months ended September 30, 2007, an increase of $0.39 per gallon or33.6%.  The increase in our average realized natural gas and NGL salesprices was primarily a result of significantly higher index prices for naturalgas and posted prices for NGLs during the three months ended September 30,2008 compared to the three months ended September 30, 2007.

 

Cash received from our counterparty on cash flow swap contracts fornatural gas derivative transactions that closed during the three months ended September 30,2008 totaled $1.1 million compared to $1.5 million for the three months ended September 30,2007.  The $1.1 million gain for the three months ended September 30,2008 increased averaged realized natural gas prices to $7.57

 

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per MMBtu from $7.44 perMMBtu, an increase of $0.13 per MMBtu. The $1.5 million gain for the three months ended September 30, 2007increased averaged realized natural gas prices to $5.20 per MMBtu from $5.00per MMBtu, an increase of $0.20 per MMBtu. Cash paid to our counterparty oncash flow swap contracts for NGL derivative transactions that closed during thethree months ended September 30, 2008 totaled $2.5 million compared to$0.6 million for the three months ended September 30, 2007.  The $2.5 million loss for the three months ended September 30, 2008reduced averaged realized NGL prices to $1.55 per gallon from $1.65 per gallon,a decrease of $0.10 per gallon. The $0.6 million loss for the three monthsended September 30, 2007 reduced averaged realized NGL prices to $1.16 pergallon from $1.18 per gallon, a decrease of $0.02 per gallon.

 

Compression revenues were $1.2 million for the each of the three monthsended September 30, 2008 and 2007.

 

***Midstream Purchases.*** Midstream purchases were $81.9 million for the three months ended September 30,2008 compared to $45.8 million for the three months ended September 30,2007, an increase of $36.1 million, or 78.9%.  The $36.1 million increaseis primarily due to volume growth at the Woodford Shale gathering system, theexpanded Badlands gathering system, including the nitrogen rejection plant,which commenced operation in August 2007 and higher natural gas and NGLpurchase prices, resulting in increased midstream purchases for all of thegathering systems.

 

 ***Midstream Segment Margin .*** Midstream segment margin was $32.6 million for the three months ended September 30,2008 compared to $20.6 million for the three months ended September 30,2007, an increase of $12.0 million, or 58.2%. The increase is primarily due to favorable gross processing spreads,significantly higher average realized natural gas and NGL prices, volume growthat the Woodford Shale gathering system and volume growth at the expandedBadlands gathering system, including the nitrogen rejection plant, whichcommenced operations in August 2007. As a percent of midstream revenues, midstream segment margin was 28.5%and 31.1% for the three months ended September 30, 2008 and 2007,respectively, a reduction of 2.6%.  Thisreduction is attributable to net losses on closed/settled derivativetransactions and unrealized non-cash losses on derivative transactions for thethree months ended September 30, 2008 totaling $1.3 million, after beingoffset by an unrealized non-cash gain of $5.6 million related to anon-qualifying mark-to-market cash flow derivative for forecasted sales in2010, compared to net gains of $0.9 million on closed/settled derivativetransactions and unrealized non-cash gains on derivative transactions for thethree months ended September 30, 2007.

 

***Operations andMaintenance.***  Operations and maintenance expensetotaled $7.9 million for the three months ended September 30, 2008compared with $6.2 million for the three months ended September 30, 2007,an increase of $1.7 million, or 28.0%. Of this increase, $1.2 million wasattributable to increased operations and maintenance at the expanded Badlandsgathering system and $0.4 million was attributable to increased operations andmaintenance at the Woodford Shale gathering system.

 

***Depreciation,Amortization and Accretion.***  Depreciation,amortization and accretion expense totaled $9.8 million for the three monthsended September 30, 2008 compared with $7.9 million for the three monthsended September 30, 2007, an increase of $2.0 million, or 25.1 %.  Ofthis increase, $0.6 million was attributable to increased depreciation on theexpanded Badlands gathering system, $0.7 million was attributable to the WoodfordShale gathering system and $0.3 million was attributable to increaseddepreciation on the Bakken gathering system.

 

***Bad Debt.*** During the three months ended September 30, 2008, Hiland Partners recordeda reversal of an uncollectible trade accounts receivable of $7.8 millionrelated to a receivable from a significant customer in which they hadpreviously reserved an allowance for uncollectible accounts of $8.1 millionduring the second quarter of 2008. Accordingly, Hiland Partners has decreasedits reserve for uncollectible accounts to $0.3 million, which represents theremaining potential exposure to this significant customer. Neither we norHiland Partners had any bad debts for the three months ended September 30,2007.

 

***General andAdministrative.***  General and administrative expensetotaled $2.6 million for the three months ended September 30, 2008compared with $2.1 million for the three months ended September 30, 2007,an increase of $0.5 million, or 26.4%. Salaries expense increased by $0.5million as a result of increased non-cash unit based compensation and increasedstaffing during the three months ended September 30, 2008 as compared tothe three months ended September 30, 2007.

 

***Other Income(Expense).*** Other income (expense) totaled $(3.3)million for the three months ended September 30, 2008 compared with $(3.2)million for the three months ended September 30, 2007, an increase inexpense of $0.2 million.  The increase is primarily attributable toadditional interest expense from borrowings on our credit facility to fundexpansions at the Badlands gathering system, the Woodford Shale gatheringsystem, and the Kinta gathering systems, after being offset by lower interestrates incurred during the three months ended September 30, 2008 comparedto interest rates incurred during the three months ended September 30,2007.

 

***MinorityInterest.  *** Minority interest in income ofHiland Partners, which represents the allocation of Hiland Partners loss orearnings to its limited partner interests not owned by Hiland Holdings, totaled$6.8 million for the three months ended September 30, 2008 compared to$0.9 million for the three months ended September 30, 2007, an increase of$5.9 million.

 

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**NineMonths Ended September 30, 2008 Compared with Nine Months Ended September 30,2007**

 

***Revenues.***  Total revenues(midstream and compression) were $322.7 million for the nine months ended September 30,2008 compared to $195.3 million for the nine months ended September 30,2007, an increase of $127.4 million, or 65.2%.  This $127.4 millionincrease was primarily due to: (i) increased natural gas sales volumes of14,052 MMBtu/day (MMBtu per day) and increased NGL sales volumes of 901Bbls/day (Bbls per day) related to the Woodford Shale gathering system whichcommenced operation in April 2007, (ii) increased NGL sales volumesof 467 Bbls/day attributable to the expanded Badlands gathering system,including the nitrogen rejection plant, which commenced operation in August 2007and (iii) significantly higher average realized natural gas and NGL salesprices for the nine months ended September 30, 2008 as compared to thesame period in 2007, resulting in increased revenue at all of the gatheringsystems.  Revenues from compression assets were the same for both periods.

 

Midstream revenues were$319.1 million for the nine months ended September 30, 2008 compared to$191.7 million for the nine months ended September 30, 2007, an increaseof $127.4 million, or 66.4%. Of this $127.4 million increase in midstreamrevenues, approximately $37.1 million was attributable to revenues fromincreased natural gas and NGL sales volumes at the Woodford Shale, Badlands,Bakken and Matli gathering systems and approximately $90.3 million wasattributable to significantly higher average realized natural gas and NGL salesprices for the nine months ended September 30, 2008 as compared to the sameperiod in 2007, resulting in increased revenues for all of the gatheringsystems.

 

Inlet natural gas was245,098 Mcf/d (Mcf per day) for the nine months ended September 30, 2008compared to 210,878 Mcf/d for the nine months ended September 30, 2007, anincrease of 34,220 Mcf/d, or 16.2%.  Thisincrease is primarily attributable to volume growth at the Woodford Shale andBadlands gathering systems offset by volume declines at the Eagle Chief andKinta gathering systems.

 

Natural gas sales volumeswere 89,615 MMBtu/d for the nine months ended September 30, 2008 comparedto 78,998 MMBtu/d for the nine months ended September 30, 2007, anincrease of 10,617 MMBtu/d, or 13.4%.  This 10,617 MMBtu/d net increase innatural gas sales volumes was attributable to increased natural gas salesvolumes at the Woodford Shale, Bakken and Matli gathering systems offset byreduced natural gas sales volumes at the Eagle Chief and Kinta gatheringsystems.

 

NGL sales volumes were5,763 Bbls/d for the nine months ended September 30, 2008 compared to4,340 Bbls/d for the nine months ended September 30, 2007, a net increaseof 1,423 Bbls/d, or 32.8%.  This net increase is primarily attributable tovolume growth at the Woodford Shale and Badlands gathering systems.

 

Average realized naturalgas sales prices were $8.00 per MMBtu for the nine months ended September 30,2008 compared to $5.78 per MMBtu for the nine months ended September 30,2007, an increase of $2.22 per MMBtu, or 38.4%.  Average realized NGLsales prices were $1.53 per gallon for the nine months ended September 30,2008 compared to $1.07 per gallon for the nine months ended September 30,2007, an increase of $0.46 per gallon or 43.0%.  The increase in ouraverage realized natural gas and NGL sales prices was primarily a result ofsignificantly higher index prices for natural gas and posted prices for NGLsduring the nine months ended September 30, 2008 compared to the ninemonths ended September 30, 2007.

 

Cash received from ourcounterparty on cash flow swap contracts for natural gas derivativetransactions that closed during the nine months ended September 30, 2008totaled $1.4 million compared to $3.5 million for the nine months ended September 30,2007.  The $1.4 million gain for the nine months ended September 30,2008 increased averaged realized natural gas prices to $8.00 per MMBtu from$7.95 per MMBtu, an increase of $0.05 per MMBtu.  The $3.5 million gain for the nine monthsended September 30, 2007 increased averaged realized natural gas prices to$5.78 per MMBtu from $5.62 per MMBtu, an increase of $0.16 per MMBtu.  Cash paid to our counterparty on cash flowswap contracts for NGL derivative transactions that closed during the ninemonths ended September 30, 2008 totaled $7.9 million compared to $1.1million for the nine months ended September 30, 2007.   The $7.8million loss for the nine months ended September 30, 2008 reduced averagedrealized NGL prices to $1.53 per gallon from $1.64 per gallon, a decrease of$0.11 per gallon. The $1.1 million loss for the nine months ended September 30,2007 reduced averaged realized NGL prices to $1.07 per gallon from $1.09 pergallon, a decrease of $0.02 per gallon.

 

Compression revenues were$3.6 million for the each of the nine months ended September 30, 2008 and2007.

 

***Midstream Purchases.***  Midstreampurchases were $238.6 million for the nine months ended September 30, 2008compared to $137.3 million for the nine months ended September 30, 2007,an increase of $101.3 million, or 73.7%.  The $101.3 million increase isprimarily due to volume growth at the Woodford Shale gathering system whichcommenced operation in April 2007, the expanded Badlands gathering system,including the nitrogen rejection plant, which commenced operation in August 2007and higher natural gas and NGL purchase prices, resulting in increasedmidstream purchases for all of the gathering systems.

 

 ***Midstream Segment Margin .***  Midstreamsegment margin was $80.5 million for the nine months ended September 30,2008 compared to $54.4 million for the nine months ended September 30,2007, an increase of $26.1 million, or 48.0%. The increase is

 

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primarily due to favorable gross processing spreads, significantlyhigher average realized natural gas and NGL prices, volume growth at theWoodford Shale gathering system which commenced operation in April 2007and volume growth at the expanded Badlands gathering system, including thenitrogen rejection plant, which commenced operations in August 2007. As apercent of midstream revenues, midstream segment margin was 25.2% and 28.4% forthe nine months ended September 30, 2008 and 2007, respectively, areduction of 3.1%.  This reduction isattributable to net losses on closed/settled derivative transactions andunrealized non-cash losses on derivative transactions for the nine months endedSeptember 30, 2008 totaling $6.4 million, after being offset by anunrealized non-cash gain of $3.6 million related to a non-qualifyingmark-to-market cash flow derivative for forecasted sales in 2010, compared tonet gains of $2.4 million on closed/settled derivative transactions andunrealized non-cash gains on derivative transactions for the nine months ended September 30,2007. The increase in midstream segment margin was offset by approximately $2.3million of forgone margin as a result of the Badlands nitrogen rejection plantbeing temporarily taken out of service due to equipment failure during the ninemonths ended September 30, 2008.

 

***Operations and Maintenance.*** Operations and maintenance expense totaled $22.2 million for the nine monthsended September 30, 2008 compared with $16.1 million for the nine monthsended September 30, 2007, an increase of $6.1 million, or 37.8%. Of thisincrease, $3.6 million was attributable to increased operations and maintenanceat the expanded Badlands gathering system and $2.2 million was attributable toincreased operations and maintenance at the Eagle Chief, Matli and WoodfordShale gathering systems.

 

***Depreciation, Amortization and Accretion.*** Depreciation, amortization and accretion expense totaled $28.5 million for thenine months ended September 30, 2008 compared with $22.2 million for thenine months ended September 30, 2007, an increase of $6.3 million, or 28.3%.  Of this increase, $2.2 million was attributable to increaseddepreciation on the expanded Badlands gathering system, $1.7 million wasattributable to the Woodford Shale gathering system and $1.1 million wasattributable to increased depreciation on the Bakken gathering system.

 

***General and Administrative.*** General and administrative expense totaled $7.6 million for the nine monthsended September 30, 2008 compared with $6.4 million for the nine monthsended September 30, 2007, an increase of $1.2 million or 19.3%. Salariesincreased $1.4 million in the nine months ended September 30, 2008 ascompared to the nine months ended September 30, 2007 due to increasednon-cash unit based compensation and increased staffing during the nine monthsended September 30, 2008 as compared to the nine months ended September 30,2007.

 

***Other Income (Expense).*** Otherincome (expense) totaled $(10.1) million for the nine months ended September 30,2008 compared with $(7.6) million for the nine months ended September 30,2007, an increase in expense of $2.6 million.  The increase is primarilyattributable to additional interest expense from borrowings on our creditfacility to fund expansions at the Badlands gathering system, the WoodfordShale gathering system, and the Kinta gathering systems, after being offset bylower interest rates incurred during the nine months ended September 30,2008 compared to interest rates incurred during the nine months ended September 30,2007.

 

***Minority Interest.  ***Minority interest in income of Hiland Partners, which represents the allocationof Hiland Partners loss or earnings to its limited partner interests not ownedby Hiland Holdings totaled $4.4 million for the nine months ended September 30,2008 compared to $2.1 million for the nine months ended September 30,2007, an increase of $2.3 million.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

***Disruption to Functioning of Capital Markets***

 

Multiple events during2008 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 issue debt and equity atprices that are similar to offerings in recent years will be limited over thenext three to six months and possibly longer should capital markets remainconstrained. Although Hiland Partners intends to move forward with its plannedinternal growth projects, Hiland Partners may revise the timing and scope ofthese projects as necessary to adapt to existing economic conditions and thebenefits expected to accrue to our and Hiland Partners’ unitholders from HilandPartners expansion activities may be muted by substantial cost of capitalincreases during this period.

 

***Overview***

 

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

 

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operating performance and, more broadly, on the availability of equityand debt financing, which will be affected by prevailing economic conditions inHiland Partners’ industry and financial, business and other factors, many ofwhich are beyond Hiland Partners’ control.

 

***Cash Flows from Operating Activities***

 

 Cash flows from operating activities decreasedby $2.6 million to $25.5 million for the nine months ended September 30,2008 from $28.2 million for the nine months ended September 30,2007.  During the nine months ended September 30, 2008 we receivedcash flows from customers of approximately $303.7 million attributable toincreased natural gas and NGLs volumes and significantly higher averagerealized natural gas and NGL sales prices, had cash payments to our suppliersand employees of approximately $268.5 million and payment of interest expenseof $9.7 million, net of amounts capitalized, resulting in cash received fromoperating activities of $25.5 million. During the same nine month period in2007, we received cash flows from customers of approximately $196.1 million,had cash payments to our suppliers and employees of approximately $160.4million and payment of interest expense of $7.5 million, net of amountscapitalized, resulting in cash received from our operating activities of $28.2million.

 

Changes in cash receiptsand payments are primarily due to the timing of collections at the end of ourreporting periods. Hiland Partners collects and pays large receivables andpayables at the end of each calendar month. The timing of these payments andreceipts may vary by a day or two between month-end periods and causefluctuations in cash received or paid. Working capital items, exclusive ofcash, used $16.6 million of cash flows from operating activities during thenine months ended September 30, 2008 and used $0.6 million in cash flowsfrom operating activities during the nine months ended September 30, 2007.

 

Net income for the ninemonths ended September 30, 2008 was $10.9 million, an increase of $7.3million from a net income of $3.6 million for the nine months ended September 30,2007.  Depreciation and amortization increased by $6.3 million to $28.4million for the nine months ended September 30, 2008 from $22.1 millionfor the nine months ended September 30, 2007.

 

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

 

Cash flows used forinvesting activities, which represent investments in property and equipmentdecreased by $24.8 million to $37.1 million for the nine months ended September 30,2008 from $61.9 million for the nine months ended September 30, 2007primarily due to reduced capital investing in the nine months ended September 30,2008 related to the Badlands nitrogen rejection plant which was underconstruction during the first nine months of 2007.

 

***Cash Flows from Financing Activities***

 

Cash flows from financingactivities decreased to $13.6 million for the nine months ended September 30,2008 from $32.1 million for the nine months ended September 30, 2007, adecrease of $18.5 million. During the nine months ended September 30,2008, Hiland Partners borrowed $41.0 million under its credit facility to fundits internal expansion projects, received capital contributions of $1.0 millionas a result of issuing Hiland Partners common units due to the exercise ofvested unit options, incurred debt issuance costs of $0.4 million associatedwith the fourth amendment to its credit facility amended in February 2008and made $0.4 million payments on capital lease obligations. During the nine monthsended September 30, 2008, we made distributions of $18.2 million to ourunitholders and Hiland Partners distributed $9.9 million to its minorityinterest unitholders.

 

During the nine monthsended September 30, 2007, Hiland Partners borrowed $54.0 million under itscredit facility to fund internal expansion projects, received capitalcontributions of $1.0 million as a result of issuing common units due to theexercise of vested unit options, incurred debt issuance costs of $0.5 millionassociated with the third amendment to the credit facility, made $0.2 millionpayments on capital lease obligations and paid deferred offering costs of $0.2million associated with Hiland Partners’ S-3/A registration statement filedwith the SEC on January 23, 2007. During the nine months ended September 30,2007, we made distributions of $13.7 million to our unitholders and HilandPartners distributed $8.5 million to its minority interest unitholders.

 

***Capital Requirements***

 

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

 

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

 

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

 

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

 

***North Dakota Bakken***

 

Hiland Partners plans tomake an initial capital investment of approximately $10.0 million by the end of2008 with additional investments of up to $17.0 million over the next threeyears to build gas processing and treating facilities and install fieldgathering, compression and associated equipment at the Bakken Shale play innorthwestern North Dakota in which CLR has dedicated approximately 129,000gross acres to Hiland Partners.  As of September 30,2008, Hiland Partners has initially invested $0.4 million in the project.  The expected startup of the initial phase ofthe project should occur no later than the second quarter of 2009.

 

***Woodford Shale***

 

HilandPartners is continuing to expand the Woodford Shale gathering system located inthe Woodford Shale reservoir area in theArkoma Basin of southeastern Oklahoma. The gatheringsystem is being designed to provide low-pressure and highly reliable gathering,compression and dehydration services. During the third quarter of 2008, HilandPartners invested approximately $10.4 million to expand its Woodford Shale gatheringsystem to provide takeaway capacity in excess approximately 65,000 Mcf/d, at17,400 horsepower of compression. As of September 30, 2008, HilandPartners has invested a total of $39.8 million in this internal expansionproject.

 

***FinancialDerivatives and Commodity Hedges***

 

Hiland Partners hasentered into certain financial derivative instruments that are classified ascash flow hedges in accordance with SFAS 133 and relate to forecasted sales in2008 and 2009, and a non-qualifying mark-to-market cash flow derivative thatrelates to forecasted sales in 2010. Hiland Partners entered into theseinstruments to hedge the forecasted natural gas and natural gas liquid sales orpurchases against the variability in expected future cash flows attributable tochanges in market prices. The swap instruments are contractual agreementsbetween counterparties to exchange obligations of money as the underlyingnatural gas or natural gas liquids are sold or purchased. Under these swapagreements, Hiland Partners either receives or pays a monthly net settlementthat is determined by the difference between a fixed price and a floating pricebased on certain indices for the relevant contract period for the agreed uponvolumes.

 

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

 

| ** **                                                 | ** ** | ** **  | ** ** | **Average**           | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------|------------|-------------|------------|-----------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | ** **  | ** ** | **Fixed**             | ** ** | **Asset**           | ** ** |
| **Description and Production Period**       | ** ** | **Volume**  | ** ** | **Price**             | ** ** | **(Liability)**     | ** ** |
| ** **                                                 | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**  | ** ** | ** **          | ** ** |
| Natural Gas -  Sold Fixed for Floating Price Swaps         |       |        |       |                  |       |                |       |
| October 2008  - September 2009                   |       | 2,097,000   |       | $                     | 7.42       |                | $          | 4,521 |   |
| October 2009  - December 2009                    |       | 534,000     |       | $                     | 7.30       |                | 1,016      |   |
| January 2010  - December 2010                    |       | 2,136,000   |       | $                     | 10.50      |                | 3,975      |   |
|                                                       |       |        |       |                  |       | $                   | 9,512      |   |
|                                                       |       |        |       |                  |       |                |       |
|                                                       |       | **(MMBtu)** |       | **(per MMBtu)**  |       |                |       |
| Natural Gas -  Buy Fixed for Floating Price Swaps          |       |        |       |                  |       |                |       |
| October 2008  - December 2008                    |       | 180,288     |       | $                     | 6.93       |                | $          | (396 | ) |
|                                                       |       |        |       |                  |       |                |       |
| ** **                                                 | ** ** | **(Bbls)**  | ** ** | **(per Gallon)** | ** ** | ** **          | ** ** |
| Natural Gas  Liquids - Sold Fixed for Floating Price Swaps |       |        |       |                  |       |                |       |
| October 2008  - December 2008                    |       | 110,442     |       | $                     | 1.31       |                | $          | (1,230 | ) |

 

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

 

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***Off-BalanceSheet Arrangements***

 

Neither we nor HilandPartners had any significant off-balance sheet arrangements as of September 30,2008.

 

***AvailableCredit***

 

Credit markets in theUnited States and around the world remain constrained due to a lack ofliquidity and confidence in a number of financial institutions. Investorscontinue to seek perceived safe investments in securities of the United Statesgovernment rather than corporate issues. Hiland Partners may at times experiencedifficulty accessing the long-term credit markets due to prevailing marketconditions. Additionally, existing constraints in the credit markets mayincrease the rates Hiland Partners is charged for utilizing these markets.Notwithstanding the continuing weakness in the United States credit markets,Hiland Partners expects that its available liquidity is sufficient to meet itsoperating and capital requirements into 2009 and for the foreseeable future.

 

***Credit Facilities***

 

***Hiland HoldingsCredit 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 permits us, if certain conditions are met, to increaseborrowing capacity by up to an additional $25.0 million. The credit facilitywill be secured by all of our ownership interests in Hiland Partners and itsgeneral partner, other than the 2% general partner interest and the incentivedistribution rights.

 

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

 

Indebtedness under thecredit facility will bear interest, at our option, at either: (i) analternate base rate plus an applicable margin ranging from 100 to 150 basispoints per annum or (ii) LIBOR plus an applicable margin ranging from 200to 250 basis points per annum in each case based on our ratio of consolidatedfunded debt to EBITDA. The alternate base rate is equal to the greatest of: (a) theprime rate in effect on such day, (b) the base CD rate in effect on suchday plus 1.50% and (c) the federal funds effective rate in effect on suchday plus 1/2 of 1%. We have elected for the indebtedness to bear interest atLIBOR plus the applicable margin. A letter of credit fee will be payable forthe aggregate amount of letters of credit issued under the credit facility at apercentage per annum equal to 2.0%. A commitment fee ranging from 25 to 50basis points per annum based on our ratio of consolidated funded debt to EBITDAwill be payable on the average daily unused portion of the credit facility forthe quarter most recently ended. At September 30, 2008, the interest rateon outstanding borrowings from our credit facility was 4.49%.

 

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

 

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

 

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

 

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

 

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

 

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As of September 30,2008, we had $0.7 million outstanding under this credit facility and werein compliance with our financial covenants. The outstanding $0.7 million, which matures on September 25,2009,  is included in accrued liabilitiesand other in the balance sheet.

 

***Hiland Partners Credit Facility***

 

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

 

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

 

In addition, the fourthamendment provides for an accordion feature, which permits Hiland Partners, ifcertain conditions are met, to increase the size of the Acquisition Facility byup to $50 million and allows for the issuance of letters of credit of up to $15million in the aggregate.  The senior secured revolving credit facilityalso requires Hiland Partners to meet certain financial tests, including a maximumconsolidated funded debt to EBITDA ratio of 4.0:1.0 as of the last day of anyfiscal quarter; provided that in the event that the Partnership makes certainpermitted acquisitions or capital expenditures, this ratio may be increased to4.75:1.0 for the three fiscal quarters following the quarter in which suchacquisition or capital expenditure occurs; and a minimum interest coverageratio of 3.0:1.0. The credit facility will mature in May 2011. At thattime, the agreement will terminate and all outstanding amounts thereunder willbe due and payable.

 

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

 

Indebtedness under thecredit facility will bear interest, at Hiland Partners’ option, at either: (i) anAlternate Base Rate, as defined therin, plus an applicable margin ranging from50 to 125 basis points per annum or (ii) LIBOR plus an applicable marginranging from 150 to 225 basis points per annum based on Hiland Partners’ ratioof consolidated funded debt to EBITDA. The Alternate Base Rate is a rate perannum equal to the greatest of: (a) the Prime Rate in effect on such day, (b) thebase CD rate in effect on such day plus 1.50% and (c) the Federal Fundseffective rate in effect on such day plus 1/2 of 1%. Hiland Partners has electedfor the indebtedness to bear interest at LIBOR 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 any 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 September 30, 2008,the interest rate on outstanding borrowings from Hiland Partners’ creditfacility was 4.76%.

 

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

 

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

 

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

 

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

 

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As of September 30,2008, Hiland Partners had $262.1 million outstanding under its creditfacility and was in compliance with its financial covenants.

 

***Impactof Inflation***

 

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

 

**Recent Accounting Pronouncements**

 

On April 25, 2008,the Financial Accounting Standards Board (“FASB”) 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 will beeffective as of January 1, 2009 and will apply only to intangible assetsacquired after that date. Retroactive application to previously acquiredintangible assets is prohibited.  The adoption of FSP 142-3 is notexpected to have a material impact on our financial position, results ofoperations or cash flows.

 

On March 19, 2008,the FASB issued SFAS No. 161, “Disclosures about Derivative Instrumentsand Hedging Activities,” an amendment of SFAS 133 (“SFAS 161”). SFAS 161 isintended to improve transparency in financial reporting by requiring enhanceddisclosures of an entity’s derivative instruments and hedging activities andtheir effects on the entity’s financial position, financial performance, andcash flows. SFAS 161 is effective prospectively for financial statements issuedfor fiscal years and interim periods beginning after November 15, 2008,with early application encouraged. SFAS 161 encourages, but does not require,comparative disclosures for periods prior to its initial adoption. SFAS 161amends the current qualitative and quantitative disclosure requirements forderivative instruments and hedging activities set forth in SFAS 133 andgenerally increases the level of aggregation/disaggregation that will berequired in an entity’s financial statements. We are currently reviewing SFAS161 to determine the effect it will have on our financial statements anddisclosures therein.

 

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

 

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

 

 In December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interests in Consolidated Financial Statements – an amendmentof ARB No. 51” (“SFAS 160”). SFAS 160 establishes accounting and reportingstandards that require the ownership interests in subsidiaries held by partiesother than the parent (minority interest) be clearly identified, labeled, andpresented in the consolidated balance sheet within equity, but separate fromthe parent’s equity. SFAS 160 requires the equity amount of consolidated netincome attributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated income statement andthat changes in a parent’s ownership interest while the parent retains itscontrolling financial interest in its subsidiary be accounted for consistentlyand similarly as equity transactions. Consolidated net income and

 

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comprehensive income will be determined without deducting minorityinterest; however, earnings-per-share information will continue to becalculated on the basis of the net income attributable to the parent’sshareholders. Additionally, SFAS 160 establishes a single method for accountingfor changes in a parent’s ownership interest in a subsidiary that does notresult in deconsolidation and that the parent recognize a gain or loss in netincome when a subsidiary is deconsolidated. SFAS 160 is effective for fiscalyears beginning on or after December 15, 2008. Early adoption is notpermitted. We do not expect SFAS 160 will have a material impact on ourfinancial position, results of operations or cash flows.

 

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

 

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

 

**Significant Accounting Policies and Estimates**

 

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

 

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

 

*Derivatives.  *We utilize derivative financial instruments to reduce commodity price risks. Wedo not hold or issue derivative financial instruments for trading purposes.Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments andHedging Activities”, which was amended in June 2000 by SFAS 138 and in May 2003by SFAS 149, establishes accounting and reporting standards for derivativeinstruments and hedging activities. It requires that an entity recognize allderivatives as either assets or liabilities in the statement of financialcondition and measure those instruments at fair value. Derivatives that are notdesignated as hedges are adjusted to fair value through income. If thederivative is designated as a hedge, depending upon the nature of the hedge,changes in the fair value of the derivatives are either offset against the fairvalue of assets, liabilities or firm commitments through income, or recognizedin other comprehensive income until the hedged item is recognized in income.The ineffective portion of a derivative’s change in fair value is immediatelyrecognized into income. If a derivative no longer qualifies for hedgeaccounting the amounts in accumulated other comprehensive income will beimmediately charged to operations.

 

*Asset Retirement Obligations.*    SFAS No. 143, “Accountingfor Asset Retirement Obligations” (“SFAS 143”), requires entities to record thefair value of a liability for an asset retirement obligation in the period inwhich it is incurred and a corresponding increase in

 

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the carrying amount of the related long-livedasset. Subsequently, the asset retirement cost is allocated to expense using asystematic and rational method and the liability is accreted to measure thechange in liability due to the passage of time. The primary impact of SFAS 143relates to our estimated costs for dismantling and site restoration of certainof our plants and pipelines. Estimating future asset retirement obligationsrequires us to make estimates and judgments regarding timing, existence of aliability, as well as what constitutes adequate restoration. We use the presentvalue of estimated cash flows related to our asset retirement obligation todetermine the fair value, generally as estimated by third party consultants.The present value calculation requires us to make numerous assumptions andjudgments, including the ultimate costs of dismantling and site restoration,inflation factors, credit adjusted discount rates, timing of settlement andchanges in the legal, regulatory, environmental and political environments. Tothe extent future revisions to these assumptions impact the present value ofthe existing asset retirement obligation liability, a corresponding adjustmentwill be required to the related asset. We believe the estimates and judgmentsreflected in our financial statements are reasonable but are necessarilysubject to the uncertainties we have just described. Accordingly, anysignificant variance in any of the above assumptions or factors couldmaterially affect our cash flows.

 

*Impairment of Long-Lived Assets.*    In accordance withSFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” we evaluate our long-lived assets, including intangible assets, ofidentifiable business activities for impairment when events or changes incircumstances indicate, in management’s judgment, that the carrying value ofsuch assets may not be recoverable. The determination of whether impairment hasoccurred is based on management’s estimate of undiscounted future cash flowsattributable to the assets as compared to the carrying value of the assets. Ifimpairment has occurred, the amount of the impairment recognized is determinedby estimating the fair value for the assets and recording a provision for lossif the carrying value is greater than fair value. For assets identified to bedisposed of in the future, the carrying value of these assets is compared tothe estimated fair value less the cost to sell to determine if impairment isrequired. Until the assets are disposed of, an estimate of the fair value isre-determined when related events or circumstances change.

 

Whendetermining whether impairment of one of our long-lived assets has occurred, wemust estimate the undiscounted cash flows attributable to the asset or assetgroup. Our estimate of cash flows is based on assumptions regarding the volumeof reserves providing asset cash flow and future NGL product and natural gasprices. The amount of reserves and drilling activity are dependent in part onnatural gas prices. Projections of reserves and future commodity prices areinherently subjective and contingent upon a number of variable factors,including, but not limited to:

 

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

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

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

·* *our ability to negotiate favorable marketingagreements;

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

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

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

 

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

 

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

 

We estimate the fairvalue of each unit option granted on the date of grant using the AmericanBinomial option-pricing model. In estimating the fair value of each option, weuse our peer group volatility averages as determined on the option grant dates. We calculate expected lives of the options under the simplified method asprescribed by the SEC Staff Accounting Bulletin 107 and have used a risk freeinterest rate based on the applicable U.S. Treasury yield in effect at the timeof grant. We estimate the fair value of each restricted unit granted on thedate of grant based on the unit closing price on that same date.  Ourcompensation expense for these awards is recognized on the graded vestingattribution method. Units to be issued under our unit incentive plan may be fromnewly issued units.

 

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

 

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

 

***Commodity Price Risks.  ***Hiland Partners profitability is affected by volatility in prevailing NGL andnatural gas prices. Historically, changes in the prices of most NGL productshave generally correlated with changes in the price of crude oil. NGL andnatural gas prices are volatile and are impacted by changes in the supply anddemand for NGLs and natural gas, as well as market

 

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uncertainty. 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 September 30, 2008and September 30, 2007, respectively, the impact on our midstream segmentmargin of a $0.01 per gallon change (increase or decrease) in NGL pricescoupled with a $0.10 per MMBtu change (increase or decrease) in the price ofnatural gas.

 

| ** **                    | ** ** | ** ** | ** ** | **Natural Gas Price Change ($/MMBtu)** | ** ** |
|-------------------------------|------------|------------|------------|------------------------------------------------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **2008**                                                   | ** ** | **2007** | ** ** |
|                          |       |       |       | $                                                          | 0.10       |   | $ | (0.10 | ) | $ | 0.10 |   | $ | (0.10 | ) |
| **NGL  Price Change ($/gal)** |       | $          | 0.01       |                                                       | $          | 130,000 |   | $ | 156,000 |   | $ | 461,000 |   | $ | 109,000 |   |
|                          |       | $          | (0.01      | )                                                          | $          | (159,000 | ) | $ | (134,000 | ) | $ | (111,000 | ) | $ | (464,000 | ) |

 

The increase in commodityexposure is the result of increased natural gas and NGL product volumes in thethree months ended September 30, 2008 compared to the three months ended September 30,2007. The magnitude of the impact on total segment margin of changes in naturalgas and NGL prices presented may not be representative of the magnitude of theimpact on total segment margin for different commodity prices or contractportfolios. Natural gas prices can also affect our profitability indirectly byinfluencing the level of drilling activity and related opportunities for ourservices.

 

We manage this commodityprice exposure through an integrated strategy that includes management of ourcontract portfolio, optimization of our assets and the use of derivativecontracts. As a result of these derivative swap contracts, we have hedged aportion of our expected exposure to natural gas prices and natural gas liquidsprices in 2008, 2009 and 2010. We continually monitor our hedging and contractportfolio and expect to continue to adjust our hedge position as conditionswarrant. The following table provides information about our derivativeinstruments for the periods indicated:

 

| ** **                                                 | ** ** | ** **  | ** ** | **Average**           | ** ** | **Fair Value** | ** ** |
|------------------------------------------------------------|------------|-------------|------------|-----------------------|------------|---------------------|------------|
| ** **                                                 | ** ** | ** **  | ** ** | **Fixed**             | ** ** | **Asset**           | ** ** |
| **Description and Production Period**       | ** ** | **Volume**  | ** ** | **Price**             | ** ** | **(Liability)**     | ** ** |
| ** **                                                 | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)**  | ** ** | ** **          | ** ** |
| Natural Gas -  Sold Fixed for Floating Price Swaps         |       |        |       |                  |       |                |       |
| October 2008  - September 2009                   |       | 2,097,000   |       | $                     | 7.42       |                | $          | 4,521 |   |
| October 2009  - December 2009                    |       | 534,000     |       | $                     | 7.30       |                | 1,016      |   |
| January 2010  - December 2010                    |       | 2,136,000   |       | $                     | 10.50      |                | 3,975      |   |
|                                                       |       |        |       |                  |       | $                   | 9,512      |   |
|                                                       |       |        |       |                  |       |                |       |
|                                                       |       | **(MMBtu)** |       | **(per MMBtu)**  |       |                |       |
| Natural Gas -  Buy Fixed for Floating Price Swaps          |       |        |       |                  |       |                |       |
| October 2008  - December 2008                    |       | 180,288     |       | $                     | 6.93       |                | $          | (396 | ) |
|                                                       |       |        |       |                  |       |                |       |
| ** **                                                 | ** ** | **(Bbls)**  | ** ** | **(per Gallon)** | ** ** | ** **          | ** ** |
| Natural Gas  Liquids - Sold Fixed for Floating Price Swaps |       |        |       |                  |       |                |       |
| October 2008  - December 2008                    |       | 110,442     |       | $                     | 1.31       |                | $          | (1,230 | ) |

 

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

 

***Interest Rate Risk.***   Wehave elected for the indebtedness to bear interest at LIBOR plus the applicablemargin.We are exposed to changes in the LIBOR rate as a result of our creditfacility and Hiland Partners’ credit facility, which have floating interestrates. As of September 30, 2008 we had approximately $0.7 million ofindebtedness outstanding under our credit facility which was used to financethe costs related to the closing of our $25.0 million secured revolvingcredit facility. As of September 30, 2008, Hiland Partners hadapproximately $262.1 million of indebtedness outstanding under its creditfacility. The impact of a 100 basis point increase in interest rates on theamount of current debt would, for the remainder of 2008, result in anannualized increase in interest expense and a corresponding decrease inannualized net income of approximately $2.6 million. On October 7, 2008,Hiland Partners entered into a floating-to-fixedinterest rate swap agreement with an investment grade counterpartywhereby they pay a monthly fixed interest rate of 2.245% and receive a monthlyvariable rate based on the one month posted LIBOR interest rate on a notionalamount of $100.0 million.  This swapagreement is effective on January 2, 2009 and terminates on January 1,2010.

 

***Credit Risk.****  * Counterparties pursuant to the terms of theircontractual obligations expose Hiland Partners to potential losses as a resultof nonperformance. Hiland Partners’ five largest customers for the three monthsended September 30, 2008 accounting for approximately 18%, 14%, 10%, 7%and 5%, respectively, of revenues. Consequently, changes within one or more ofthese companies’

 

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operationshave the potential to impact, both positively and negatively, our creditexposure and make us subject to risks of loss resulting from nonpayment ornonperformance by these or any of Hiland Partners’ other customers. Anymaterial nonpayment or nonperformance by its key customers could materially andadversely affect our business, financial condition or results of operations andreduce Hiland Partners’ ability to make distributions to its unitholders.Furthermore, some of Hiland Partners’ customers may be highly leveraged andsubject to their own operating and regulatory risks, which increases the riskthat they may default on their obligations to Hiland Partners. Hiland Partners’counterparties for HilandPartners’ derivative instruments as ofSeptember 30, 2008 are BP EnergyCompany and Bank of Oklahoma, N.A.

 

On July 22, 2008, SemGroup, L.P. and certainsubsidiaries filed voluntary petitions for reorganization under Chapter 11 ofthe U.S. Bankruptcy Code.  Affiliates ofSemGroup, L.P. purchase Hiland Partners natural gas liquids and condensate,primarily at their Bakken and Badlands plants and gathering systems.  During the second quarter 2008, HilandPartners increased their allowance for doubtful accounts and bad debt expenseby $8.1 million for related product sales through June 30, 2008. On October 20,2008, the United States Bankruptcy Court for the District of Delaware enteredan order approving the assumption of a Natural Gas Liquids Marketing Agreement(the “SemStream Agreement”) between SemStream, L.P., an affiliate of SemGroup,L.P., and Hiland Partners relating to the sale of natural gas liquids andcondensate at our Bakken and Badlands plants and gathering systems. As a resultof the assumption, and in accordance with the order, on October 21, 2008,SemStream paid $12.1 million to Hiland Partners, representing amounts owed toHiland Partners from SemStream for June and July 2008 product salesunder the SemStream Agreement. The assumption of the SemStream Agreementrestores Hiland Partners and SemStream, L.P. to their pre-bankruptcycontractual relationship.

 

HilandPartners’ third quarter results of operations reflect a reversal of $7.8million of the $8.1 million allowance for doubtful accounts and bad debtexpense previously recorded on their income statement in the second quarter of2008. After receipt of the October 21 payment, Hiland Partners’ totalpre-petition credit exposure to SemGroup, related to condensate sales toSemCrude, LLC, and outside of the SemStream Agreement, is approximately $0.3million, which Hiland Partners’ has reserved as of September 30, 2008.

 

**Item4.  Controlsand Procedures**

 

**Evaluation of Disclosure Controls and Procedures**

 

(a)          Evaluation of disclosurecontrols and procedures.

 

As required by Rule 13a-15(b) under theSecurities Exchange Act of 1934, as amended, we have evaluated, under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)as of the end of the period covered by this Quarterly Report on Form 10-Q.Based upon that evaluation, our principal executive officer and principalfinancial officer concluded that our disclosure controls and procedures wereeffective as of September 30, 2008, to ensure that information isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate, to allowtimely decisions regarding required disclosure and is recorded, processed,summarized and reported within the time periods specified in the rules andforms of the SEC.

 

(b) Changes ininternal control over financial reporting.

 

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

 

**PART IIOTHER INFORMATION**

 

**Item1.  LegalProceedings**

 

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

 

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**Item 1A. Risk Factors**

 

Inaddition to the other information set forth in this report, you shouldcarefully consider the factors discussed in Part I, Item 1A. “Risk Factors”in our Annual Report on Form 10-K for the year ended December 31,2007, 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 our Company. Additional risks and uncertainties not currentlyknown to us or that we currently deem to be immaterial also may materiallyadversely affect our business, financial condition and/ or operating results.

 

**RisksInherent in an Investment in Us**

 

***Increases ininterest rates could increase our borrowing costs, adversely impact our unitprice and our ability to issue additional equity, which could have an adverseeffect on our cash flows and our ability to fund our growth.***

 

Due to the recentvolatility and decline in the credit markets, the interest rate on our creditfacility could increase, which would reduce our cash flows.  In addition, interest rates on future creditfacilities and debt offerings could be higher than current levels, causing ourfinancing costs to increase accordingly. As with other yield-oriented securities, the market price for our unitswill be affected by the level of our cash distributions and implieddistribution yield.  The distributionyield is often used by investors to compare and rank yield-oriented securitiesfor investment decision-making purposes. Therefore, changes in interest rates, either positive or negative, mayaffect the yield requirements of investors who invest in our units, and a risinginterest rate environment could have an adverse effect on our unit price andour ability to issue additional equity in order to make acquisitions, toreduce debt or for other purposes.

 

***Our cash flow is affected by the volatility of natural gasand NGL product prices, which could adversely affect our ability to makedistributions to unitholders.***

 

We are subject tosignificant risks due to frequent and often substantial fluctuations incommodity prices. In the past, the prices of natural gas and NGLs have beenextremely volatile, and we expect this volatility to continue. The markets andprices for natural gas and NGLs depend upon factors beyond our control. Thesefactors include demand for crude oil, natural gas and NGLs, which fluctuatewith changes in market and economic conditions and other factors, including:

 

·       theimpact of weather on the demand for oil and natural gas;

 

·       thelevel of domestic oil and natural gas production;

 

·       theavailability of imported oil and natural gas;

 

·       actionstaken by foreign oil and gas producing nations;

 

·       theavailability of local, intrastate and interstate transportation systems;

 

·       theavailability and marketing of competitive fuels;

 

·       theimpact of energy conservation efforts; and

 

·       theextent of governmental regulation and taxation.

 

Hiland Partners’ operatesunder two types of contractual arrangements under which its total segmentmargin is exposed to increases and decreases in the price of natural gas andNGLs: percentage-of-proceeds and percentage-of-index arrangements. Underpercentage-of-proceeds arrangements, Hiland Partners generally purchasesnatural gas from producers for an agreed percentage of proceeds or upon anindex related price, and then sell the resulting residue gas and NGLs or NGLproducts at index related prices. Under percentage-of-index arrangements,Hiland Partners purchases natural gas from producers at a fixed percentage ofthe index price for the natural gas Hilnad Partners produces and subsequentlysell the residue gas and NGLs or NGL products at market prices. Under both ofthese types of contracts Hiland Partners’ revenues and total segment marginincrease or decrease, whichever is applicable, as the price of natural gas andNGLs fluctuates.

 

**RisksInherent in Hiland Partners’ Business**

 

Because we aresubstantially dependent on the distributions we receive from Hiland Partners,risks to Hiland Partners’ operations are also risks to us. We have set forthbelow risks to Hiland Partners’ business and operations, the occurrence ofwhich could negatively impact its financial performance and decrease the amountof cash it is able to distribute to us.

 

***Because of thenatural decline in production from existing wells, our success depends onHiland Partners’ ability to obtain new supplies of natural gas, which involvesfactors beyond its control.  Any decreasein supplies of natural gas in Hiland Partners’ areas of operation couldadversely affect Hiland Partners’ business and operating results.***

 

Hiland Partners’gathering systems and processing plants are dependent on the level ofproduction from oil and natural gas wells that supply its systems with naturalgas and from which production will naturally decline over time.  As a result, Hiland Partners’ cash flowsassociated with these wells will also decline over time.  In order to maintain or increase throughputvolume levels on Hiland Partners’ gathering systems and the asset utilizationrates at its natural gas processing plants, Hiland Partners must continuallyobtain new supplies.  The primary factorsaffecting Hiland Partners’ ability to obtain new supplies of natural gas andattract new customers to its assets are: the level of successful drillingactivity near Hiland Partners’ gathering systems and its ability to competewith other gathering and processing companies for volumes from successful newwells.

 

The level of natural gasdrilling activity is dependent on economic and business factors beyond HilandPartners’ control.  The primary factorsthat impacts drilling decisions are crude oil and natural gas prices.  Sustained declines in crude oil and naturalgas prices could result in decreases in exploration and development activitiesin the fields served by Hiland Partners’ assets, which would lead to reducedutilization of these assets.

 

In addition, producersmay decrease their activity levels due to the current deterioration in thecredit markets.  Many of Hiland Partners’customers finance their activities through cash flow from operations, theincurrence of debt or the issuance of equity.  Recently, there has been a significant decline in the credit markets andthe availability of credit. Additionally, many of Hiland Partners’ customers’ equity values havesubstantially declined.  The combinationof a reduction of cash flow resulting from declines in commodity prices, areduction in borrowing bases under reserve-based credit facilities and the lackof availability of debt or equity financing may result in a significantreduction in Hiland Partners’ customers’ spending.  For example, a number of Hiland Partners’customers have announced reduced capital expenditure budgets for the remainderof 2008 and 2009.

 

Other factors that impactproduction decisions include producers’ capital budget limitations, the abilityof producers to obtain necessary drilling and other governmental permits andregulatory changes.  Because of thesefactors, even if additional crude oil or natural gas reserves were discoveredin areas served by Hiland Partners’ assets, producers may choose not to developthose reserves.  If Hiland Partners wasnot able to obtain new supplies of natural gas to replace the natural declinein volumes from existing wells due to reductions in drilling activity orcompetition, throughput volumes on its pipelines and the utilization rates ofits processing facilities would decline, which could have a material adverseeffect on Hiland Partners’ business, results of operations and financialcondition.

 

***Completionof significant, unbudgeted expansion projects may require debt and/or equityfinancing which may not be available to Hiland Partners on acceptable terms, orat all.***

 

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Hiland Partners plans tofund its expansion capital expenditures, including any future expansions it mayundertake, with proceeds from sales of its debt and equity securities andborrowings under its revolving credit facility; however, we cannot be certainthat Hiland Partners will be able to issue its debt and equity securities onterms or in the proportions that we expect, or at all, and Hiland Partners maybe unable refinance its revolving credit facility when it expires.   In addition, Hiland Partners may be unableto obtain adequate funding under its current revolving credit facility becauseits lending counterparties may be unwilling or unable to meet their fundingobligations.

 

Global financial marketsand economic conditions have been, and continue to be, disrupted and volatile.The debt and equity capital markets have been exceedingly distressed. Theseissues, along with significant write-offs in the financial services sector, there-pricing of credit risk and the current weak economic conditions have made,and will likely continue to make, it difficult to obtain funding.

 

The cost of raising moneyin the debt and equity capital markets has increased substantially while theavailability of funds from those markets generally has diminishedsignificantly. Also, as a result of concerns about the stability of financialmarkets generally and the solvency of counterparties specifically, the cost ofobtaining money from the credit markets generally has increased as many lendersand institutional investors have increased interest rates, enacted tighterlending standards, refused to refinance existing debt at maturity at all or onterms similar to our current debt and reduced and, in some cases, ceased toprovide funding to borrowers.

 

A significant increase inHiland Partners’ indebtedness, or an increase in Hiland Partners’ indebtednessthat is proportionately greater than its issuances of equity, as well as thecredit market and debt and equity capital market conditions discussed abovecould negatively impact Hiland Partners’ ability to remain in compliance withthe financial covenants under its revolving credit agreement which could have amaterial adverse effect on its financial condition, results of operations andcash flows. If Hiland Partners is unable to finance its expansion projects asexpected, it could be required to seek alternative financing, the terms ofwhich may not be attractive to Hiland Partners, or to revise or cancel itsexpansion plans.  If Hiland Partners isunable to finance its expansion projects as expected, this could have a materialadverse effect on Hiland Partners’ operations, which could reduce HilandPartners’ ability to make distributions to its unitholders, including us.

 

***Increases ininterest rates could increase Hiland Partners’ borrowing costs, adverselyimpact its unit price and its ability to issue additional equity, which couldhave an adverse effect on Hiland Partners’ cash flows and its ability to fundits growth.***

 

Due to the recentvolatility and decline in the credit markets, the interest rate on HilandPartners’ credit facility could increase, which would reduce its cashflows.  In addition, interest rates onfuture credit facilities and debt offerings could be higher than currentlevels, causing Hiland Partners’ financing costs to increase accordingly.  As with other yield-oriented securities, themarket price for Hiland Partners’ units will be affected by the level of itscash distributions and implied distribution yield.  The distribution yield is often used byinvestors to compare and rank yield-oriented securities for investmentdecision-making purposes.  Therefore,changes in interest rates, either positive or negative, may affect the yieldrequirements of investors who invest in Hiland Partners’ units, and a rising interestrate environment could have an adverse effect on Hiland Partners’ unit priceand its ability to issue additional equity in order to make acquisitions,to reduce debt or for other purposes.

 

***Hiland Partners’ cash flow is affected by the volatility ofnatural gas and NGL product prices, which could adversely affect its ability tomake distributions to us.***

 

Hiland Partners issubject to significant risks due to frequent and often substantial fluctuationsin commodity prices. In the past, the prices of natural gas and NGLs have beenextremely volatile, and we expect this volatility to continue. The markets andprices for natural gas and NGLs depend upon factors beyond Hiland Partners’control. These factors include demand for oil, natural gas and NGLs, whichfluctuate with changes in market and economic conditions and other factors,including:

 

·       theimpact of weather on the demand for oil and natural gas;

 

·       thelevel of domestic oil and natural gas production;

 

·       theavailability of imported oil and natural gas;

 

·       actionstaken by foreign oil and gas producing nations;

 

·       theavailability of local, intrastate and interstate transportation systems;

 

·       theavailability and marketing of competitive fuels;

 

·       theimpact of energy conservation efforts; and

 

·       theextent of governmental regulation and taxation.

 

HilandPartners operates under two types of contractual arrangements under which itstotal segment margin is exposed to increases and decreases in the price ofnatural gas and NGLs: percentage-of-proceeds and percentage-of-indexarrangements. Under percentage-of-proceeds arrangements, Hiland Partnersgenerally purchases natural gas from producers for an agreed percentage ofproceeds or upon an index related price, and then sell the resulting residuegas and NGLs or NGL products at index related prices. Under percentage-of-indexarrangements, Hiland Partners purchases natural gas from producers at a fixedpercentage of the index price for the natural gas it produces and subsequentlysells the residue gas and NGLs or NGL products at market prices. Under both ofthese types of contracts Hiland Partners’ revenues and total segment marginincrease or decrease, whichever is applicable, as the price of natural gas andNGLs fluctuates.

 

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

 

None.

 

**Item 3. Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5. Other Information**

 

None.

 

**Item 6. Exhibits**

 
| **Exhibit  Number** | ** ** | ** ** | ** ** | **Description**                                                                                                                                                                                                                                                            |
|---------------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | —     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Registration Statement on Form S-1  (File No. 333-134491)).                                                                   |
| 3.2                 |       | —     |       | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.2 of Registrant’s Registration  Statement on Form S-1 (File No. 333-134491)).                                                |
| 3.3                 |       | —     |       | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                     |
| 3.4                 |       | —     |       | Form of  Amended and Restated Limited Liability Company Agreement of Hiland Partners  GP Holdings, LLC(incorporated by reference to Exhibit 3.4 of  Registrant’s Statement on form S-1. (File No. 333-134491))                                    |
| 4.1                 |       | —     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Registration Statement on Form S-1  (File No. 333-134491)).                                                                   |
| 4.2                 |       | —     |       | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.2 of Registrant’s Registration  Statement on Form S-1 (File No. 333-134491)).                                                |
| 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                 |       | —     |       | Form of  Amended and Restated Limited Liability Company Agreement of Hiland Partners  GP Holdings, LLC(incorporated by reference to Exhibit 3.4 of  Registrant’s Statement on form S-1. (File No. 333-134491))                                    |
| 10.1                |       | —     |       | Credit Agreement  dated as of February 15, 2005 among Hiland Operating, LLC and  MidFirst Bank (incorporated by reference to exhibit 10.1 of Hiland  Partners, LP’s annual report on Form 10-K filed on March 30,  2005).               |
| 10.2+               |       | —     |       | Hiland  Partners, LP Long-Term Incentive Plan (incorporated by reference to  Exhibit 10.2 of Hiland Partners, LP’s Registration Statement on Form S-1  (File No. 333-119908)).                                                                    |
| 10.3                |       | —     |       | Compression  Services Agreement, effective as of January 28, 2005, by and among  Hiland Partners, LP and CLR (incorporated by reference to  exhibit 10.3 of Hiland Partners, LP’s annual report on  Form 10-K filed on March 30, 2005). |

 

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| 10.4       |   | — |   | Gas Purchase  Contract between CLR and Continental Gas, Inc. dated as of  August 1, 1999(incorporated by reference to Exhibit 10.5 of Hiland  Partners, LP’s Registration Statement or Form S-1  (File No. 333-119908)).                                                                                                    |
|------------|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5† |   | — |   | Gas Purchase  Contract between Chesapeake Energy Marketing, Inc. and Continental  Gas, Inc. (incorporated by reference to Exhibit 10.5 of Hiland  Partners, LP’s Registration Statement or Form S-1  (File No. 333-119908)).                                                                                                |
| 10.6† |   | — |   | Gas Purchase  Contract between Magic Circle Energy Corporation and Magic Circle Gas  (incorporated by reference to Exhibit 10.6 of Hiland Partners, LP’s  Registration Statement on Form S-1 (File No. 333-119908)).                                                                                                                  |
| 10.7† |   | — |   | Gas Purchase  Contract between Range Resources Corporation and Continental Gas, Inc.  (incorporated by reference to Exhibit 10.7 of Hiland Partners, LP’s  Registration Statement on Form S-1 (File No. 333-119908)).                                                                                                            |
| 10.8+      |   | — |   | Form of  Unit Option Grant (incorporated by reference to Exhibit 10.9 of Hiland  Partners, LP’s Registration Statement on Form S-1 (File  No. 333-119908)).                                                                                                                                                                           |
| 10.9       |   | — |   | Omnibus  Agreement among CLR, Hiland Partners, LLC, Harold Hamm, Hiland Partners  GP, LLC, Continental Gas Holdings, Inc., and Hiland Partners, LP  effective as of February 15, 2005 (incorporated by reference to  exhibit 10.10 of Hiland Partners, LP’s annual report on  Form 10-K filed on March 30, 2005). |
| 10.10+     |   | — |   | Director’s  Compensation Summary (incorporated by reference to exhibit 10.11 of  Hiland Partners, LP’s annual report on Form 10-K filed on  March 30, 2005).                                                                                                                                                                     |
| 10.11+     |   | — |   | Form of  Restricted Unit Grant Agreement (incorporated by reference to  exhibit 10.1 of Hiland Partners, LP’s Form 8-K filed on  November 14, 2005).                                                                                                                                                                             |
| 10.12      |   | — |   | First Amendment,  dated as of September 26, 2005 to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders  thereto (incorporated by reference to exhibit 10.1 of Hiland  Partners, LP’s Form 8-K filed on September 29, 2005).                                                   |
| 10.13      |   | — |   | Gas Purchase  Agreement among Hiland Partners, LP and CLR dated November 8, 2005  (incorporated by reference to exhibit 10.1 of Hiland Partners,   LP’s form 8-K filed on November 10, 2005).                                                                                                                               |
| 10.14+     |   | — |   | Form of  Hiland Holdings GP, LP Long-Term Incentive Plan (incorporated by  reference to Exhibit 10.14 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                                                  |
| 10.15      |   | — |   | Credit Agreement  dated as of May 1, 2006 between Hiland Partners GP, LLC and  Midfirst Bank (incorporated by reference to Exhibit 10.15 of  Registrant’s Statement on form S-1 (File No. 333-134491)).                                                                                                                               |
| 10.16      |   | — |   | Unit Purchase  Agreement dated May 1, 2006 by and between Hiland Partners, LP and  Hiland Partners GP, LLC (incorporated by reference to Exhibit 10.1 of  Hiland Partners, LP’s Form 8-K filed on May 3, 2005).                                                                                                                       |
| 10.17      |   | — |   | Asset Purchase  Agreement dated March 30, 2006 by and between Hiland Operating, LLC and  Energy Gas Gathering, L.L.C. (incorporated by reference to Exhibit 10.2  of Hiland Partners, LP’s Form 8-K filed on May 3, 2005).                                                                                                            |
| 10.18      |   | — |   | Second  Amendment, dated as of June 8, 2006, to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders thereto  (incorporated by reference to Exhibit 10.1 of Hiland Partners, LP’s  Form 8-K filed on June 13, 2006).                                                                      |
| 10.19      |   | — |   | Form of  Restricted Unit Grant Agreement of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 10.19 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                                             |
| 10.20+     |   | — |   | Form of  Unit Option Grant Agreement of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 10.20 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                                                 |
| 10.21+     |   | — |   | Form of  Phantom Unit Grant Agreement of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 10.21 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                                                |
| 10.22      |   | — |   | Non-Competition  Agreement dated September 25, 2006 (2006 by and among Hiland Partners,  LP, Hiland Holdings GP, LP and Hiland Partners GP Holdings, LLC (incorporated  by reference to Exhibit 10.22 of Hiland Partners, LP’s Form 8-K  filed on September 29, 2006). .                                                              |
| 10.23      |   | — |   | Credit Agreement  dated as of September 25, 2006 between Hiland Holdings GP, LP and  Midfirst Bank (incorporated by reference to Exhibit 10.23 of  Registrant’s Statement on form S-1 (File No. 333-134491)).                                                                                                                         |

 

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| 10.24 |   | — |   | Retention Agreement,  dated as of March 14, 2007, by and among Randy Moeder, Hiland Partners  GP, LLC, Hiland Partners GP Holdings, LLC and the other parties listed on the  signature page thereto. (incorporated by reference to exhibit 10.1 of  Registrant’s Form 8-K filed on March 15, 2007). |
|-------|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25 |   | — |   | Third Amendment,  dated as of July 13, 2007, to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders thereto  (incorporated by reference to exhibit 10.1 of Hiland Partners, LP  Form 8-K filed on July 18, 2007).                                                |
| 10.26 |   | — |   | Form of  Phantom Unit Grant Agreement (incorporated by reference to exhibit 10.1 of  Hiland Partners, LP Form 8-K filed on November 13, 2007).                                                                                                                                                                |
| 10.27 |   | — |   | Fourth  Amendment, dated as of February 6, 2008 to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders thereto  (incorporated by reference to exhibit 10.1 of Hiland Partners, LP  Form 8-K filed on February 12, 2008).                                         |
| 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).                                                                                                                     |
| 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.                                                                                                                                                                                                                         |

 

----

*+*Denotesa management contract or compensatory plan or arrangement.

†Portions of this exhibit have been omitted pursuant to arequest for confidential treatment.

 

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**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 10th day of November, 2008.

 
|            | **HILAND  HOLDINGS GP, LP** |
|------------|-----------------------------|
| ** ** | **By:**                     | **Hiland  Partners GP Holdings, LLC, its general partner** |
| ** ** | ** **                  | ** ** |
|       | By:                         | /s/ Joseph L. Griffin |
|       |                        | Joseph L. Griffin |
| * *   | * *                    | *Chief  Executive Officer, President and Director  (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)* |

 

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**Exhibit Index**

 
| **Exhibit  Number** | ** ** | ** ** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                |
|---------------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | —     |       | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                                                         |
| 3.2                 |       | —     |       | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.2 of Registrant’s Statement on  form S-1 (File No. 333-134491)).                                                                                                                                                      |
| 3.3                 |       | —     |       | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                                                         |
| 3.4                 |       | —     |       | Form of  Amended and Restated Limited Liability Company Agreement of Hiland Partners  GP Holdings, LLC(incorporated by reference to Exhibit 3.4 of  Registrant’s Statement on form S-1.) (File No. 333-134491))                                                                                                                            |
| 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 3.2 of Registrant’s Statement on  form S-1 (File No. 333-134491)).                                                                                                                                                      |
| 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                 |       | —     |       | Form of  Amended and Restated Limited Liability Company Agreement of Hiland Partners  GP Holdings, LLC(incorporated by reference to Exhibit 3.4 of  Registrant’s Statement on form S-1.) (File No. 333-134491))                                                                                                                            |
| 10.1                |       | —     |       | Credit Agreement  dated as of February 15, 2005 among Hiland Operating, LLC and  MidFirst Bank (incorporated by reference to exhibit 10.1 of Hiland  Partners, LP’s annual report on Form 10-K filed on March 30,  2005).                                                                                                   |
| 10.2+               |       | —     |       | Hiland  Partners, LP Long-Term Incentive Plan (incorporated by reference to  Exhibit 10.2 of Hiland Partners, LP’s Registration Statement on  Form S-1 (File No. 333-119908)).                                                                                                                                                        |
| 10.3                |       | —     |       | Compression  Services Agreement, effective as of January 28, 2005, by and among  Hiland Partners, LP and CLR (incorporated by reference to  exhibit 10.3 of Hiland Partners, LP’s annual report on  Form 10-K filed on March 30, 2005).                                                                                     |
| 10.4                |       | —     |       | Gas Purchase  Contract between CLR and Continental Gas, Inc. dated as of  August 1, 1999(incorporated by reference to Exhibit 10.5 of Hiland  Partners, LP’s Registration Statement or Form S-1 (File No. 333-119908)).                                                                                                     |
| 10.5†          |       | —     |       | Gas Purchase  Contract between Chesapeake Energy Marketing, Inc. and Continental  Gas, Inc. (incorporated by reference to Exhibit 10.5 of Hiland  Partners, LP’s Registration Statement or Form S-1  (File No. 333-119908)).                                                                                                |
| 10.6†          |       | —     |       | Gas Purchase  Contract between Magic Circle Energy Corporation and Magic Circle Gas  (incorporated by reference to Exhibit 10.6 of Hiland Partners, LP’s  Registration Statement on Form S-1 (File No. 333-119908)).                                                                                                                  |
| 10.7†          |       | —     |       | Gas Purchase  Contract between Range Resources Corporation and Continental Gas, Inc.  (incorporated by reference to Exhibit 10.7 of Hiland Partners, LP’s  Registration Statement on Form S-1 (File No. 333-119908)).                                                                                                            |
| 10.8+               |       | —     |       | Form of  Unit Option Grant (incorporated by reference to Exhibit 10.9 of Hiland  Partners, LP’s Registration Statement on Form S-1 (File  No. 333-119908)).                                                                                                                                                                           |
| 10.9                |       | —     |       | Omnibus  Agreement among CLR, Hiland Partners, LLC, Harold Hamm, Hiland Partners  GP, LLC, Continental Gas Holdings, Inc., and Hiland Partners, LP  effective as of February 15, 2005 (incorporated by reference to  exhibit 10.10 of Hiland Partners, LP’s annual report on  Form 10-K filed on March 30, 2005). |
| 10.10+              |       | —     |       | Director’s  Compensation Summary (incorporated by reference to exhibit 10.11 of  Hiland Partners, LP’s annual report on Form 10-K filed on  March 30, 2005).                                                                                                                                                                     |
| 10.11+              |       | —     |       | Form of  Restricted Unit Grant Agreement (incorporated by reference to  exhibit 10.1 of Hiland Partners, LP’s Form 8-K filed on  November 14, 2005).                                                                                                                                                                             |
| 10.12               |       | —     |       | First Amendment,  dated as of September 26, 2005 to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders  thereto (incorporated by reference to exhibit 10.1 of Hiland  Partners, LP’s Form 8-K filed on September 29, 2005).                                                   |
| 10.13               |       | —     |       | Gas Purchase  Agreement among Hiland Partners, LP and CLR dated November 8, 2005  (incorporated by reference to exhibit 10.1 of Hiland Partners,   LP’s form 8-K filed on November 10, 2005).                                                                                                                               |

 

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Table of Contents

 
| 10.14+ |   | — |   | Form of  Hiland Holdings GP, LP Long-Term Incentive Plan (incorporated by  reference to Exhibit 10.14 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                                |
|--------|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.15  |   | — |   | Credit Agreement  dated as of May 1, 2006 between Hiland Partners GP, LLC and  Midfirst Bank (incorporated by reference to Exhibit 10.15 of  Registrant’s Statement on form S-1 (File No. 333-134491)).                                                                                             |
| 10.16  |   | — |   | Unit Purchase  Agreement dated May 1, 2006 by and between Hiland Partners, LP and  Hiland Partners GP, LLC (incorporated by reference to Exhibit 10.1 of  Hiland Partners, LP’s Form 8-K filed on May 3, 2005).                                                                                     |
| 10.17  |   | — |   | Asset Purchase  Agreement dated March 30, 2006 by and between Hiland Operating, LLC and  Energy Gas Gathering, L.L.C. (incorporated by reference to Exhibit 10.2  of Hiland Partners, LP’s Form 8-K filed on May 3, 2005).                                                                          |
| 10.18  |   | — |   | Second  Amendment, dated as of June 8, 2006, to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders thereto  (incorporated by reference to Exhibit 10.1 of Hiland Partners, LP’s  Form 8-K filed on June 13, 2006).                                    |
| 10.19  |   | — |   | Form of  Restricted Unit Grant Agreement of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 10.19 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                           |
| 10.20+ |   | — |   | Form of  Unit Option Grant Agreement of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 10.20 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                               |
| 10.21+ |   | — |   | Form of  Phantom Unit Grant Agreement of Hiland Holdings GP, LP (incorporated by  reference to Exhibit 10.21 of Registrant’s Statement on form S-1 (File  No. 333-134491)).                                                                                                                              |
| 10.22  |   | — |   | Non-Competition  Agreement dated September 25, 2006 (2006 by and among Hiland Partners,  LP, Hiland Holdings GP, LP and Hiland Partners GP Holdings, LLC (incorporated  by reference to Exhibit 10.22 of Hiland Partners, LP’s Form 8-K  filed on September 29, 2006). .                            |
| 10.23  |   | — |   | Credit Agreement  dated as of September 25, 2006 between Hiland Holdings GP, LP and  Midfirst Bank (incorporated by reference to Exhibit 10.23 of  Registrant’s Statement on form S-1 (File No. 333-134491)).                                                                                       |
| 10.24  |   | — |   | Retention  Agreement, dated as of March 14, 2007, by and among Randy Moeder, Hiland  Partners GP, LLC, Hiland Partners GP Holdings, LLC and the other parties  listed on the signature page thereto. (incorporated by reference to  exhibit 10.1 of Registrant’s Form 8-K filed on March 15, 2007). |
| 10.25  |   | — |   | Third Amendment,  dated as of July 13, 2007, to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders thereto  (incorporated by reference to exhibit 10.1 of Hiland Partners, LP  Form 8-K filed on July 18, 2007).                                                |
| 10.26  |   | — |   | Form of  Phantom Unit Grant Agreement (incorporated by reference to exhibit 10.1 of  Hiland Partners, LP Form 8-K filed on November 13, 2007).                                                                                                                                                                |
| 10.27  |   | — |   | Fourth  Amendment, dated as of February 6, 2008 to Credit Agreement dated as of  February 15, 2005 among Hiland Operating, LLC and the lenders thereto  (incorporated by reference to exhibit 10.1 of Hiland Partners, LP  Form 8-K filed on February 12, 2008).                                         |
| 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).                                                                                                                     |
| 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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*+*Denotesa management contract or compensatory plan or arrangement.

†Portions of this exhibit have been omitted pursuant to arequest for confidential treatment.

 

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