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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

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

 

**FOR THEQUARTERLY PERIOD ENDED JUNE 30, 2009**

 

**OR**

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

 

**FOR THETRANSITION 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’stelephone number, including area code)

 

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

 

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

 

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

 

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

 

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

 

The number of the registrant’s outstanding equity units as of August 7,2009 was 21,607,500 common units.

 

 

 

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**HILAND HOLDINGS GP, LP**

 

**INDEX**

 
| **PART I. FINANCIAL  INFORMATION**                                                              |
|------------------------------------------------------------------------------------------------------|
| Item 1. Financial  Statements (Unaudited, except December 31, 2008 Balance Sheet)               |
| Consolidated Balance Sheets                                                                          |
| Consolidated Statements of  Operations                                                               |
| Consolidated Statements of  Comprehensive Income                                                     |
| Consolidated Statements of  Cash Flows                                                               |
| Consolidated Statement of  Changes in Partners’ Equity                                          |
| Condensed  Notes to Consolidated Financial Statements (Unaudited)                                    |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risks                                 |
| Item 4. Controls and  Procedures                                                                     |
| **PART II. OTHER  INFORMATION**                                                                 |
| Item 1. Legal Proceedings                                                                            |
| Item 1A. Risk Factors                                                                                |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                 |
| Item 3.  Defaults Upon Senior Securities                                                             |
| Item 4.  Submission of Matters to a Vote of Security Holders                                         |
| Item 5. Other Information                                                                            |
| Item 6. Exhibits                                                                                     |
| SIGNATURES                                                                                           |
| Certification of CEO  under Section 302                                                         |
| Certification of CFO  under Section 302                                                         |
| Certification of CEO  under Section 906                                                         |
| Certification of CFO  under Section 906                                                         |

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Balance Sheets**

**(inthousands, except unit amounts)**

 
| ** **                                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| ** **                                                    | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                    |       |              |       |                  |       |
| **Current assets:**                                           |       |              |       |                  |       |
| Cash and cash equivalents                                     |       | $                 | 4,248      |                  | $          | 1,733 |   |
| Accounts receivable:                                          |       |              |       |                  |       |
| Trade - net of allowance for doubtful accounts of  $304       |       | 17,820            |       | 23,864                |       |
| Affiliates                                                    |       | 2,745             |       | 2,346                 |       |
|                                                          |       | 20,565            |       | 26,210                |       |
| Fair value of derivative assets                               |       | 6,188             |       | 6,851                 |       |
| Other current assets                                          |       | 1,348             |       | 1,936                 |       |
| Total current assets                                          |       | 32,349            |       | 36,730                |       |
|                                                          |       |              |       |                  |       |
| Property and equipment, net                                   |       | 349,473           |       | 349,159               |       |
| Intangibles, net                                              |       | 37,702            |       | 40,780                |       |
| Fair value of derivative assets                               |       | 1,597             |       | 7,141                 |       |
| Other assets, net                                             |       | 1,464             |       | 1,750                 |       |
|                                                          |       |              |       |                  |       |
| **Total assets**                                              |       | $                 | 422,585    |                  | $          | 435,560 |   |
|                                                          |       |              |       |                  |       |
| **LIABILITIES AND PARTNERSHIP EQUITY**                        | ** ** | ** **        | ** ** | ** **            | ** ** |
| **Current liabilities:**                                      |       |              |       |                  |       |
| Accounts payable                                              |       | $                 | 14,136     |                  | $          | 22,833 |   |
| Accounts payable - affiliates                                 |       | 5,236             |       | 7,823                 |       |
| Fair value of derivative liabilities                          |       | 921               |       | 1,439                 |       |
| Accrued liabilities and other                                 |       | 6,362             |       | 3,168                 |       |
| Total current liabilities                                     |       | 26,655            |       | 35,263                |       |
|                                                          |       |              |       |                  |       |
| Commitments and contingencies (Note 9)                        |       |              |       |                  |       |
| Long-term debt                                                |       | 265,117           |       | 256,466               |       |
| Fair value of derivative liabilities                          |       | 147               |       |                  |       |
| Asset retirement obligation                                   |       | 2,560             |       | 2,483                 |       |
|                                                          |       |              |       |                  |       |
| **Partners’ equity:**                                    |       |              |       |                  |       |
| Common unitholders (21,607,500 units issued and  outstanding) |       | 4,862             |       | 12,386                |       |
| Accumulated other comprehensive income                        |       | 1,370             |       | 3,111                 |       |
| Total limited partners’ equity                           |       | 6,232             |       | 15,497                |       |
| Noncontrolling partners’ interest in Hiland Partners     |       | 121,874           |       | 125,851               |       |
| Total partners’ equity                                   |       | 128,106           |       | 141,348               |       |
|                                                          |       |              |       |                  |       |
| **Total liabilities and partners’  equity**              |       | $                 | 422,585    |                  | $          | 435,560 |   |

 

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

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Statements of Operations**

**Forthe Three and Six Months Ended (Unaudited)**

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

 
| ** **                                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                   | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Revenues:**                                                                | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream operations                                                         |       |                                 |       |                               |       |   |   |   |   |
| Third parties                                                                |       | $                                    | 48,007     |                               | $          | 112,214 |   | $ | 98,118 |   | $ | 201,467 |   |
| Affiliates                                                                   |       | 867                                  |       | 2,022                              |       | 1,899 |   | 3,043 |   |
| Compression services, affiliate                                              |       | 1,205                                |       | 1,205                              |       | 2,410 |   | 2,410 |   |
| Total revenues                                                               |       | 50,079                               |       | 115,441                            |       | 102,427 |   | 206,920 |   |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| **Operating costs and expenses:**                                            | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Midstream purchases (exclusive of items****shown separately below)           | ** ** | 16,646                               | ** ** | 51,191                             | ** ** | 34,417 | ** ** | 93,642 | ** ** |
| Midstream purchases - affiliate (exclusive of items  shown separately below) |       | 10,353                               |       | 36,882                             |       | 23,798 |   | 63,049 |   |
| Operations and maintenance                                                   |       | 7,785                                |       | 7,551                              |       | 15,480 |   | 14,320 |   |
| Depreciation, amortization and accretion                                     |       | 10,824                               |       | 9,456                              |       | 21,082 |   | 18,671 |   |
| Property impairments                                                         |       | —                               |       | —                             |       | 950 |   | — |   |
| Bad debt                                                                     |       | —                               |       | 8,103                              |       | — |   | 8,103 |   |
| General and administrative                                                   |       | 4,606                                |       | 2,333                              |       | 8,433 |   | 5,018 |   |
| Total operating costs and expenses                                           |       | 50,214                               |       | 115,516                            |       | 104,160 |   | 202,803 |   |
| Operating (loss) income                                                      |       | (135                                 | )          | (75                                | )          | (1,733 | ) | 4,117 |   |
| **Other income (expense):**                                                  | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest and other income                                                    |       | 68                                   |       | 73                                 |       | 81 |   | 177 |   |
| Amortization of deferred loan costs                                          |       | (172                                 | )          | (168                               | )          | (343 | ) | (324 | ) |
| Interest expense                                                             |       | (2,691                               | )          | (3,130                             | )          | (5,049 | ) | (6,636 | ) |
| Other income (expense), net                                                  |       | (2,795                               | )          | (3,225                             | )          | (5,311 | ) | (6,783 | ) |
| **Net loss**                                                                 |       | (2,930                               | )          | (3,300                             | )          | (7,044 | ) | (2,666 | ) |
| Less: Noncontrolling partners’ interest in loss****of Hiland Partners   | ** ** | (395                                 | )          | (2,192                             | )          | (1,610 | ) | (2,398 | ) |
| **Limited Partners’ interest in net  loss**                             |       | $                                    | (2,535     | )                                  | $          | (1,108 | ) | $ | (5,434 | ) | $ | (268 | ) |
| ** **                                                                   | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net loss per limited partners’ unit  - basic**                        |       | $                                    | (0.12      | )                                  | $          | (0.05 | ) | $ | (0.25 | ) | $ | (0.01 | ) |
| **Net loss per limited partners’ unit  - diluted**                      |       | $                                    | (0.12      | )                                  | $          | (0.05 | ) | $ | (0.25 | ) | $ | (0.01 | ) |
| **Weighted average limited partners’ units  outstanding - basic**       | ** ** | 21,608                               | ** ** | 21,603                             | ** ** | 21,608 | ** ** | 21,603 | ** ** |
| **Weighted average limited partners’ units  outstanding - diluted**     | ** ** | 21,608                               | ** ** | 21,603                             | ** ** | 21,608 | ** ** | 21,603 | ** ** |

 

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

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedStatements of Comprehensive Income**

**For the Three and Six Months Ended (Unaudited, inthousands)**

 
| ** **                                                                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                           | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net loss                                                                             |       | $                                    | (2,930     | )                                  | $          | (3,300 | ) | $ | (7,044 | ) | $ | (2,666 | ) |
| Closed derivative transactions reclassified to  income                               |       | (2,171                               | )          | 3,028                              |       | (3,879 | ) | 5,083 |   |
| Change in fair value of derivatives                                                  |       | (1,332                               | )          | (7,737                             | )          | 950 |   | (10,253 | ) |
| Comprehensive loss                                                                   |       | $                                    | (6,433     | )                                  | $          | (8,009 | ) | $ | (9,973 | ) | $ | (7,836 | ) |
| Less: Comprehensive loss attributable to noncontrolling  interest in Hiland Partners |       | (1,816                               | )          | (4,106                             | )          | (2,798 | ) | (4,506 | ) |
| Comprehensive loss attributable to limited partners                                  |       | $                                    | (4,617     | )                                  | $          | (3,903 | ) | $ | (7,175 | ) | $ | (3,330 | ) |

 

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

 

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**HILANDHOLDINGS GP, LP**

**Consolidated Statements of Cash Flows**

**Forthe Six Months Ended (Unaudited, in thousands)**

 
| ** **                                                                                             | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                             | ** ** | **2009**          | ** ** | **2008**          | ** ** |
| **Cash flows  from operating activities:**                                                             |       |              |       |              |       |
| Net loss                                                                                               |       | $                 | (7,044     | )                 | $          | (2,666 | ) |
| Adjustments to reconcile  net loss to net cash provided by operating activities:                       |       |              |       |              |       |
| Depreciation and  amortization                                                                         |       | 21,004            |       | 18,605            |       |
| Accretion of asset  retirement obligation                                                              |       | 78                |       | 66                |       |
| Property impairments                                                                                   |       | 950               |       | —            |       |
| Amortization of deferred  loan cost                                                                    |       | 343               |       | 324               |       |
| (Gain) loss on derivative  transactions                                                                |       | (247              | )          | 1,935             |       |
| Net proceeds from  settlement of derivative contracts                                                  |       | 3,155             |       | —            |       |
| Unit based compensation                                                                                |       | 673               |       | 840               |       |
| Bad debt                                                                                               |       | —            |       | 8,103             |       |
| Gain on sale of assets                                                                                 |       | (3                | )          | —            |       |
| Increase in other assets                                                                               |       | (48               | )          | (146              | )          |
| (Increase) decrease in  current assets:                                                                |       |              |       |              |       |
| Accounts receivable - trade                                                                            |       | 6,044             |       | (21,989           | )          |
| Accounts receivable -  affiliates                                                                      |       | (399              | )          | (1,773            | )          |
| Other current assets                                                                                   |       | 588               |       | (951              | )          |
| Increase (decrease) in  current liabilities:                                                           |       |              |       |              |       |
| Accounts payable                                                                                       |       | (671              | )          | 11,218            |       |
| Accounts payable -  affiliates                                                                         |       | (2,587            | )          | 7,454             |       |
| Accrued liabilities and  other                                                                         |       | 2,695             |       | 1,013             |       |
| **Net cash  provided by operating activities**                                                         |       | 24,531            |       | 22,033            |       |
| **Cash flows  from investing activities:**                                                             |       |              |       |              |       |
| Purchases of property and  equipment                                                                   |       | (27,225           | )          | (20,276           | )          |
| Proceeds from disposals of  property and equipment                                                     |       | 12                |       | 6                 |       |
| **Net cash  used in investing activities**                                                             |       | (27,213           | )          | (20,270           | )          |
| **Cash flows  from financing activities:**                                                             |       |              |       |              |       |
| Proceeds from short-term  borrowings                                                                   |       | 500               |       | —            |       |
| Proceeds from long-term  borrowings                                                                    |       | 12,000            |       | 19,000            |       |
| Payments on long-term  borrowings                                                                      |       | (3,000            | )          | —            |       |
| Increase in deferred  offering cost                                                                    |       | —            |       | (7                | )          |
| Debt issuance costs                                                                                    |       | (10               | )          | (339              | )          |
| Proceeds from Hiland  Partners, LP unit options exercise                                               |       | —            |       | 1,031             |       |
| Redemption of vested  phantom units                                                                    |       | —            |       | (35               | )          |
| Distributions held in trust  refunded to Hiland Partners on forfeited unvested restricted common units |       | 22                |       | —            |       |
| Payments on capital lease  obligations                                                                 |       | (350              | )          | (235              | )          |
| Cash distributions to non-controlling  partners of Hiland Partners, LP                                 |       | (1,803            | )          | (6,421            | )          |
| Cash distributions to  unitholders                                                                     |       | (2,162            | )          | (11,566           | )          |
| **Net cash  provided by financing activities**                                                         |       | 5,197             |       | 1,428             |       |
|                                                                                                   |       |              |       |              |       |
| Increase for the period                                                                                |       | 2,515             |       | 3,191             |       |
| Beginning of period                                                                                    |       | 1,733             |       | 10,602            |       |
| **End of  period**                                                                                     |       | $                 | 4,248      |              | $          | 13,793 |   |
| Supplementary information                                                                              |       |              |       |              |       |
| Cash paid for interest, net  of amounts capitalized                                                    |       | $                 | 5,191      |              | $          | 6,437 |   |

 

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

 

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**HILAND HOLDINGS GP, LP**

**ConsolidatedStatement of Changes in Partners’ Equity**

**For the Six Months Ended June 30, 2009 (Unaudited,in thousands)**

 
| ** **                                                                                                    | ** ** | ** **      | ** ** | ** **        | ** ** | **Noncontrolling** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|--------------------|------------|------------|------------|
| ** **                                                                                                    | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | **Partners’** | ** ** | ** ** | ** ** |
| ** **                                                                                                    | ** ** | ** **      | ** ** | **Other**         | ** ** | **Interest in**    | ** ** | ** ** | ** ** |
| ** **                                                                                                    | ** ** | **Common**      | ** ** | **Comprehensive** | ** ** | **Hiland**         | ** ** | ** ** | ** ** |
| ** **                                                                                                    | ** ** | **Unitholders** | ** ** | **Income**        | ** ** | **Partners**       | ** ** | **Total**  | ** ** |
|                                                                                                          |       |            |       |              |       |               |       |       |       |
| Balance, January 1,  2009                                                                                |       | $               | 12,386     |              | $          | 3,111              |       | $          | 125,851    |   | $ | 141,348 |   |
| Periodic cash distributions                                                                                   |       | (2,162          | )          | —            |       | (1,803             | )          | (3,965     | )          |
| Unit based compensation                                                                                       |       | 72              |       | —            |       | 601                |       | 673        |       |
| Distributions held in trust  refunded to Hiland Partners on 4,250 forfeited unvested restricted common  units |       | —          |       | —            |       | 23                 |       | 23         |       |
| Other comprehensive income  reclassified to income on closed derivative transactions                          |       | —          |       | (2,307            | )          | (1,572             | )          | (3,879     | )          |
| Change in fair value of  derivatives                                                                          |       | —          |       | 566               |       | 384                |       | 950        |       |
| Net loss                                                                                                      |       | (5,434          | )          | —            |       | (1,610             | )          | (7,044     | )          |
| Balance June 30, 2009                                                                                    |       | $               | 4,862      |              | $          | 1,370              |       | $          | 121,874    |   | $ | 128,106 |   |

 

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

 

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**HILANDHOLDINGS GP, LP**

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

 

**THREE ANDSIX MONTHS ENDED JUNE 30, 2009 and 2008**

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

 

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

 

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

 

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

 

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

 

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

 

CGI operated in one segment, midstream, which involved the purchasing,gathering, compressing, dehydrating, treating, processing and marketing ofnatural gas and fractionating and marketing of natural gas liquids, or NGLs.CGI historically owned all of Hiland Partners’ natural gas gathering,processing, treating and fractionation assets other than the Worland,  Bakken, Kinta Area, Woodford Shale and NorthDakota Bakken gathering systems. Hiland Partners, LLC historically owned theWorland gathering system and compression services assets, which Hiland Partnersacquired on February 15, 2005, and the Bakken gathering system. Since itsinitial public offering, Hiland Partners has operated in midstream andcompression services segments. On September 26, 2005, Hiland Partnersacquired Hiland Partners, LLC, which at such time owned the Bakken gatheringsystem, consisting of certain southeastern Montana gathering assets, for$92.7 million, $35.0 million of which was used to retire outstandingHiland Partners, LLC indebtedness. On May 1, 2006, Hiland Partnersacquired the Kinta Area gathering assets from Enogex GasGathering, L.L.C., consisting of certain eastern Oklahoma gas gatheringassets, for $96.4 million.  HilandPartners financed this acquisition with $61.2 million of borrowings from itscredit facility and $35.0 million of proceeds from the issuance to HilandPartners GP, LLC, its general partner, of 761,714 common units and 15,545general partner equivalent units, both at $45.03 per unit. Hiland Partnersbegan construction of the Woodford Shale gathering system in the first quarterof 2007 and commenced initial start-up of its operations in April 2007.Construction on the North Dakota Bakken gathering system and processing plantbegan in October 2008 and became fully operational in May 2009.  As of June 30, 2009, Hiland Partners hasinvested approximately $22.9 million in the North Dakota Bakken gatheringsystem.

 

The unaudited financial statements for the three and six months ended June 30,2009 and 2008 included herein have been prepared pursuant to the rules andregulations of the United States Securities and Exchange Commission (the “SEC”).The interim financial statements reflect all adjustments, which in the opinionof our management, are necessary for a fair presentation of our results for theinterim periods. Such adjustments are considered to be of a normal recurringnature. **Subsequent e**ventshave been evaluated through August 10, 2009. Results of operations for thethree and six months ended June 30, 2009 are not necessarily indicative ofthe results of operations that will be realized for the year ending December 31,2009.  The accompanying consolidatedfinancial statements and notes thereto should be read in conjunction with theconsolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2008.

 

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***Principlesof Consolidation***

 

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

 

***Use of Estimates***

 

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

 

***Concentration and Credit Risk***

 

Financial instruments that potentially subjectus to concentrations of credit risk consist principally of cash and cashequivalents and receivables.  HilandPartners places cash and cash equivalents with high-quality institutions and inmoney market funds. Hiland Partners derives its revenue from customersprimarily in the oil and gas and utility industries. These industryconcentrations have the potential to impact Hiland Partners’ overall exposureto credit risk, either positively or negatively, in that its customers could beaffected by similar changes in economic, industry or other conditions. However,we believe that the credit risk posed by this industry concentration is offsetby the creditworthiness of Hiland Partners’ customer base. Hiland Partners’portfolio of accounts receivable is comprised primarily of mid-size to largedomestic corporate entities.  Thecounterparties to Hiland Partners’ commodity based derivative instruments as ofJune 30, 2009 are BP Energy Company and Bank of Oklahoma, N.A.  The counterparty to Hiland Partners’ interestrate swap as of June 30, 2009 is Wells Fargo Bank, N.A.

 

***Fair Value of FinancialInstruments***

 

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

 

***Interest Rate Risk Management***

 

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

 

***Commodity Risk Management***

 

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

 

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

 

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

 

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

 

***Long Lived Assets***

 

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

 

When determining whether impairment of one ofits long-lived assets has occurred, Hiland Partners must estimate theundiscounted future cash flows attributable to the asset or asset group. Theestimate of cash flows is based on assumptions regarding the volume of reservesproviding asset cash flow and future NGL product and natural gas prices. Theamount of reserves and drilling activities are dependent in part on crude oiland natural 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 economicconditions in regions in which Hiland Partners’ assets are located;

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

·*    *the availability and pricesof raw natural gas supply;

·*    *Hiland Partners’ ability tonegotiate favorable marketing agreements;

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

·     Hiland Partners’ dependenceon certain significant customers and producers of natural gas; and

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

 

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

 

As a result of volume declines at natural gas gathering systems locatedin Texas and Mississippi, combined with significantly reduced natural gasprices, Hiland Partners recognized impairment charges of $950 in March 2009.  No impairment charges were recognized duringthe three and six months ended June 30, 2008.

 

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

 

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

 

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

 

The noncontrolling partners’ interest in Hiland Partners presented inpartners’ equity on our consolidated balance sheets as of June 30, 2009and December 31, 2008 reflects the outside ownership interest of HilandPartners. This noncontrolling partners’ interest in Hiland Partners presentedas “Minority interests” in the mezzanine section of the balance sheet at December 31,2008 has been reclassified to the partners’ equity section on the consolidatedbalance sheet in accordance with SFAS No. 160, “Noncontrolling 

 

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

 

***Contributions to Subsidiary***

 

The Partnership directly and indirectly owns all of the equityinterests in Hiland Partners GP, LLC, the general partner of Hiland Partners.Hiland Partners GP, LLC is required to make contributions to Hiland Partnerseach time Hiland Partners issues common units or restricted common units inorder to maintain its 2% general partner ownership in Hiland Partners.Contributions for the three and six months ended June 30, 2009 and 2008were insignificant.

 

***Recent Accounting Pronouncements***

 

On June 30, 2009, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 168, “**The****FASB Accounting Standards Codification**TM******andThe Hierarchy of Generally Accepted Accounting Principles” (“FASB ASC”), areplacement of SFAS No. 162, “The Hierarchy of Generally AcceptedAccounting Principles”.** On the effective date, FASB****ASC became the source of authoritativeU.S. accounting and reporting standards for nongovernmental entities, inaddition to guidance issued by the SEC,and preparers must begin to use the Codification forperiods that begin on or about July 1, 2009. All existing accountingstandard documents are superseded and all other accounting literature notincluded in the Codification will be considered nonauthoritative. FASB ASCsignificantly changes the way financial statement preparers, auditors, andacademics perform accounting research.The FASB expects that FASB ASC will reduce the amountof time and effort required to research an accounting issue, mitigate the riskof noncompliance with standards through improved usability of the literature,provide accurate information with real-time updates as new standards are released,and assist the FASB with the research efforts required during thestandard-setting process. FASB ASC was adopted effective July 1, 2009 andwill not have a material impact on our financial statements and disclosurestherein.

 

On May 28, 2009, the FASB issued FASB Statement No. 165,“**Subsequent**Events(“SFAS 165”). SFAS 165 requires entities to disclose the date through which they haveevaluated subsequent events and whether the date corresponds with the releaseof their financial statements. SFAS 165 is effective for interim and annualperiods ending after June 15, 2009. SFAS No. 165 was adopted effective June 30, 2009 and did nothave a material impact on our financial statements and disclosures therein.

 

On April 9, 2009, the FASB issued Staff Position No. FAS107-1 and APB 28-1, “Interim Disclosures about Fair Value of FinancialInstruments” (“FAS107-1”). FAS107-1 increases the frequency of fair value disclosures to aquarterly basis instead of annual basis. FAS107-1 specifically relates to fair value disclosures for anyfinancial instruments that are not currently reflected on the balance sheet atfair value.   FAS107-1 is effective forinterim and annual periods ending after June 15, 2009.  FAS107-1 was adopted effective June 30,2009 and did not have a material impact on our financial statements anddisclosures therein.

 

On April 1, 2009, the FASB issued Staff Position No. FAS141(R)-1, “Accounting for Assets Acquired and Liabilities Assumed in a BusinessCombination That Arise from Contingencies” (“FSP141(R)-1”).  FSP 141(R)-1 amends and clarifies SFAS 141,revised 2007, “Business Combinations” to address application issues on initialand subsequent recognition, measurement, accounting and disclosure of assetsand liabilities arising from contingencies in a business combination.  FSP 141(R)-1 is effective for assets andliabilities arising from contingencies in business combinations for which theacquisition date is on or after the first annual reporting period beginning onor after December 15, 2008. FSP 141(R)-1 was adopted effective January 1,2009 and did not have a material impact on our financial statements anddisclosures therein.

 

On April 25, 2008, the FASB issued Staff Position No. FAS142-3, “Determination of the UsefulLife of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that an entityshould consider in developing renewal or extension assumptions used indetermining the useful life of recognized intangible assets under FASBStatement No. 142 (“SFAS 142”), “Goodwilland Other Intangible Assets”. In determining the useful life of anacquired intangible asset, FSP 142-3 removes the requirement from SFAS 142 foran entity to consider whether renewal of the intangible asset requiressignificant costs or material modifications to the related arrangement. FSP142-3 also replaces the previous useful life assessment criteria with arequirement that an entity considers its own experience in renewing similararrangements. If the entity has no relevant experience, it would considermarket participant assumptions regarding renewal.  FSP 142-3 was adoptedeffective January 1, 2009 and will apply to future intangible assetsacquired.  We don’t believe the adoptionof FSP 142-3 will have a material impact on our financial position, results ofoperations or cash flows.

 

On March 19, 2008, the FASB issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities”, an amendment of SFAS 133(“SFAS 161”). SFAS 161 is intended to improve transparency in financial reportingby requiring enhanced disclosures of an entity’s derivative instruments andhedging activities and their effects on the entity’s financial position,financial 

 

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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 161amended the qualitative and quantitative disclosure requirements for derivativeinstruments and hedging activities set forth in SFAS 133 and generallyincreased the level of aggregation/disaggregation required in an entity’sfinancial statements. SFAS 161 was adopted effective January 1, 2009 anddid not have a material impact on our financial statements and disclosurestherein.

 

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

 

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

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS159 expands opportunities to use fair value measurement in financial reportingand permits entities to choose to measure many financial instruments andcertain other items at fair value. SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007. SFAS 159 was adopted effective January 1,2008, at which time no financial assets or liabilities, not previously requiredto be recorded at fair value by other authoritative literature, were designatedto be recorded at fair value.  As such,the adoption of SFAS 159 did not have any impact on our financial position,results of operations or cash flows.

 

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

 

In December 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51”(“SFAS 160”). SFAS 160 establishes accounting and reporting standards thatrequire the ownership interests in subsidiaries held by parties other than theparent (minority interest) be clearly identified, labeled and presented in theconsolidated balance sheet within equity, but separate from the parent’sequity. SFAS 160 requires the equity amount of consolidated net income attributableto the parent and to the noncontrolling interest be clearly identified andpresented on the face of the consolidated income statement and that changes ina parent’s ownership interest while the parent retains its controllingfinancial 

 

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interest in itssubsidiary be accounted for consistently and similarly as equity transactions.Consolidated net income and comprehensive income are now determined withoutdeducting minority interest; however, earnings-per-share information continuesto be calculated on the basis of the net income attributable to the parent’sshareholders.  Additionally, SFAS 160establishes a single method for accounting for changes in a parent’s ownershipinterest in a subsidiary that does not result in deconsolidation and that theparent recognize a gain or loss in net income when a subsidiary isdeconsolidated.  SFAS 160 is effectivefor fiscal years beginning on or after December 15, 2008. SFAS 160 wasadopted effective January 1, 2009 and did not have a material impact onour financial position, results of operations or cash flows.

 

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

 

Upon adoption of SFAS 160 effective January 1, 2009, wereclassified $125,851 from minority interests liabilities to noncontrollingpartners’ interest in Hiland Partners in our consolidated balance sheet as of December 31,2008.  In addition, we reclassified $2,192 and $2,398 of minority interestin loss of Hiland Partners to net loss attributable to noncontrolling partners’interest in loss of Hiland Partners in our consolidated statement of operationsfor the three and six months ended June 30, 2008, respectively.  Netincome per limited partner unit has not been affected as a result of theadoption of SFAS 160.

 

**Note 2: RecentEvents**

 

On June 1, 2009, the Partnership and Hiland Partners (togetherwith the Partnership, the “Hiland Companies”) signed separate definitive mergeragreements with an affiliate of Harold Hamm, pursuant to which affiliates of Mr. Hammhave agreed to acquire for cash  (i) allof the outstanding common units of Hiland Partners (other than certainrestricted common units owned by officers and employees) not owned by thePartnership (the “Hiland Partners Merger”); and (ii) all of theoutstanding common units of the Partnership (other than certain restrictedcommon units owned by officers and employees) not owned by Mr. Hamm, hisaffiliates or the Hamm family trusts (the “Hiland Holdings Merger”).Upon consummation of the mergers, the common units of the Hiland Companies willno longer be publicly owned or publicly traded. In the mergers, the Partnership’s unitholders will receive $2.40 in cashfor each common unit they hold and Hiland Partners’ unitholders will receive$7.75 in cash for each common unit they hold. Conflicts committees comprised entirely of independent members of theboards of directors of the general partners of the Partnership and HilandPartners separately determined that the mergers are advisable, fair to and inthe best interests of the applicable Hiland Company and its public unitholders.In determining to make their recommendations to the boards of directors, eachconflicts committee considered, among other things, the fairness opinionreceived from its respective financial advisor. Based on the recommendation ofits conflicts committee, the board of directors of the general partner of eachof the Partnership and Hiland Partners has approved the applicable mergeragreement and has recommended, along with its respective conflicts committee,that the public unitholders of the Partnership and Hiland Partners, respectively,approve the applicable merger. Consummation of the Hiland Partners Merger issubject to certain conditions, including the approval of holders of a majorityof our outstanding common units not owned by Mr. Hamm, his affiliates andthe Hamm family trusts, the absence of any restraining order or injunction, andother customary closing conditions. Additionally, the obligation of Mr. Hamm and his affiliates tocomplete the Hiland Holdings Merger is contingent upon the concurrentcompletion of the Hiland Partners Merger, and the Hiland Partners Merger issubject to closing conditions similar to those described above.  There can be no assurance that the HilandHoldings Merger or any other transaction will be approved or consummated.

 

On July 1, 2009, (i) the Partnership, Hiland Partners and itsgeneral partner, Hiland Partners GP, LLC (together with Hiland Partners, the “HilandCompanies”), Hiland Partners GP Holdings, LLC, our general partner, HH GPHolding, LLC, an affiliate of Harold Hamm, HLND MergerCo, LLC, a wholly-ownedsubsidiary of HH GP Holding, LLC, Harold Hamm, Chairman of the HilandCompanies, Joseph L. Griffin, Chief Executive Officer and President of theHiland Companies, and Matthew S. Harrison, Chief Financial Officer, VicePresident—Finance and Secretary of the Hiland Companies, in connection with theAgreement and Plan of Merger, dated June 1, 2009, among Hiland Partners,Hiland Partners GP, LLC, HH GP Holding, LLC, and HLND MergerCo, LLC filed aTransaction Statement on Schedule 13E-3 with the SEC and (ii) the Partnership, HilandPartners GP Holdings, LLC, HH GP Holding, LLC, HPGP MergerCo, LLC, ContinentalGas Holdings, Inc. (an affiliate of Mr. Hamm) and Messrs. Hamm,Griffin and Harrison, in connection with the Agreement and Plan of Merger,dated June 1, 2009, among the Partnership, Hiland Partners GP Holdings,LLC, HH GP Holding, LLC and HPGP MergerCo, LLC, also filed a TransactionStatement on Schedule 13E-3 with the SEC. Concurrently with the filingof these Schedule 13E-3s, the Partnership and Hiland Partners jointlyfiled a Preliminary Proxy Statement on Schedule 14A pursuant to the definitiveversion of which the boards of directors of the general partner of each of the 

 

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Partnership andHiland Partners will be soliciting proxies from unitholders of the Partnershipand Hiland Partners in connection with the mergers of both Hiland Companies.

 

On July 10, 2009, the United States Federal Trade Commissiongranted early termination of the waiting period under the Hart-Scott-Rodino Actwith respect to the Hiland Partners Merger.

 

On June 26, 2009, Hiland Partners executed a series of hedging transactionsthat involved the unwinding of a portion of existing net “in-the-money” naturalgas swaps and entered into a new 2010 Colorado Interstate Gas (“CIG”) naturalgas swap. Hiland Partners received net proceeds of approximately $3.2 millionfrom the unwinding of the net “in-the-money” positions, of which $3.0 millionwas used to reduce indebtedness under its senior secured revolving creditfacility.

 

Three putative unitholder class action lawsuits have been filedrelating to the proposed mergers with Mr. Hamm, his affiliates, andcertain Hamm family trusts (the “Hamm Parties”).  These lawsuits are as follows: (i) *Robert Pasternack v. Hiland Partners, LP et al.*, In theCourt of Chancery of the State of Delaware, Civil Action No. 4397-VCS; (ii) *Andrew Jones v. Hiland Partners, LP et al.*, In the Court ofChancery of the State of Delaware, Civil Action No. 4558-VCS; and (iii) *Arthur G. Rosenberg v. Hiland Partners, LP et al.*, In theDistrict Court of Garfield County, State of Oklahoma, Case No. C3-09-211-02.  The lawsuits name as defendants thePartnership, Hiland Holdings, the general partner of each of the Partnershipand Hiland Partners, and the members of the board of directors of each of thePartnership and Hiland Partners.   Thelawsuits challenge both the Hiland Partners Merger and the Hiland HoldingsMerger.  The lawsuits allege claims ofbreach of the Partnership Agreement and breach of fiduciary duty on behalf of (i) apurported class of common unitholders of the Partnership and (ii) apurported class of our common unitholders of Hiland Partners.

 

On July 10, 2009, the court in which the Oklahoma case is pendinggranted our motion to stay the Oklahoma lawsuit in favor of the Delawarelawsuits.   On July 31, 2009, theplaintiff in the first-filed Delaware case (*Pasternack*)filed an Amended Class Action Complaint and a motion to enjoin themergers.   This Amended Class ActionComplaint alleges, among other things, that (i) the original considerationand revised consideration offered by the Hamm Parties is unfair and inadequate,(ii) the members of the conflicts committees of the general partner ofeach of the Partnership and Hiland Partners that were charged with reviewingthe proposals and making a recommendation to each committee’s respective boardof directors lacked any meaningful independence, (iii) the defendantsacted in bad faith in recommending and approving the Hiland Partners Merger orthe Hiland Holdings Merger, and (iv) the disclosures in the PreliminaryProxy Statement filed by the Partnership and Hiland Partners are materiallymisleading.   The *Pasternack*plaintiffseeks to preliminarily enjoin the defendants from proceeding with orconsummating the mergers and seeks an order requiring defendants to supplementthe Preliminary Proxy Statement with certain information.  We cannot predict the outcome of theselawsuits, or others, nor can we predict the amount of time and expense thatwill be required to resolve the lawsuits.

 

Additional information concerning these lawsuits may be found in the PreliminaryProxy Statement filed by the Partnership and Hiland Partners and, when filed,in the definitive joint proxy statement.

 

We and Hiland Partners have suspended quarterly cash distributions oncommon and subordinated units beginning with the first quarter distribution of2009 due to the impact of lower commodity prices and reduced drilling activityon Hiland Partners current and projected throughput volumes, midstream segmentmargins and cash flows combined with future required levels of capital expendituresand the outstanding indebtedness under ours and Hiland Partners’ senior securedrevolving credit facilities.  Under theterms of Hiland Partners’ partnership agreement, Hiland Partners’ common unitswill carry an arrearage of $0.90 per unit, representing the minimum quarterlydistribution to its common units for the first and second quarters of 2009 thatmust be paid before Hiland Partners’ can make distributions to the subordinatedunits.

 

Pursuant to theterms of our existing credit agreement, we elected to reduce the commitmentlevel on the credit facility from $10.0 million to $3.0 million on August 7,2009.  Concurrently with the reduction ofthe commitment level to $3.0 million, the existing lenders under the creditfacility assigned their interests in the facility to The Security National Bankof Enid and we entered into a first amended and restated senior secured creditagreement with The Security National Bank of Enid.   The credit facility is secured by all of ourownership interests in Hiland Partners and its general partner, other than the2% general partner interest and the incentive distribution rights. The creditfacility will mature on December 31, 2009, at which time all outstandingamounts thereunder become due and payable. As our only cash-generating assets are our 2% general partner interest,all of the incentive distribution rights and a 57.4% limited partner interestin Hiland Partners, our cash flow is completely dependent upon the ability ofHiland Partners to make cash distributions to its partners, including us.  Our credit facility matures on December 31,2009, at which time all outstanding amounts thereunder will become due andpayable.  We believe the currentavailability on the credit facility will allow us to meet our current obligationsand future expenses through maturity.  Wecannot assure that any refinancing of our credit facility can be successfullycompleted or, if completed, that the terms will be favorable to us.  If we are unable to obtain a refinancing ofour outstanding debt and Hiland Partners does not resume paying quarterly cashdistributions in amounts necessary to satisfy our obligations, we may need tosell common units in Hiland Partners to satisfy our outstanding debtobligations and any current liabilities that we may incur in the operation ofour business in the future.  See Note 7“Long-Term Debt.”

 

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

 

Property and equipment consisted of the following forthe periods indicated:

 
| ** **                                      | ** ** | **As of**         | ** ** | **As of**             | ** ** |
|-------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Land                                            |       | $                 | 295        |                  | $          | 295 |   |
| Construction in progress                        |       | 2,068             |       | 15,583                |       |
| Midstream pipeline, plants and compressors      |       | 442,680           |       | 410,330               |       |
| Compression and water injection equipment       |       | 19,417            |       | 19,391                |       |
| Other                                           |       | 4,935             |       | 4,621                 |       |
|                                            |       | 469,395           |       | 450,220               |       |
| Less: accumulated depreciation and amortization |       | 119,922           |       | 101,061               |       |
|                                            |       | $                 | 349,473    |                  | $          | 349,159 |   |

 

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During the three and six months ended June 30, 2009, wecapitalized interest of $42 and $104, respectively. We capitalized interest of$24 and $155 during the three and six months ended June 30, 2008,respectively. Hiland Partners recognized $950 of property impairment chargesrelated to natural gas gathering systems in Texas and Mississippi during thesix months ended June 30, 2009. Hiland Partners incurred no impairmentcharges during the six months ended June 30, 2008.

 

In accordance with SFAS No. 143, “Accounting for Asset RetirementObligations” (“SFAS 143”), we have recorded the fair value of liabilities forasset retirement obligations in the periods in which they are incurred andcorresponding increases in the carrying amounts of the related long-livedassets. The asset retirement costs are subsequently allocated to expense usinga systematic and rational method and the liabilities are accreted to measure thechange in liability due to the passage of time. The provisions of SFAS 143primarily apply to dismantlement and site restoration of certain of HilandPartners’ plants and pipelines. We have evaluated Hiland Partners’ assetretirement obligations as of June 30, 2009 and have determined thatrevisions in the carrying values are not necessary at this time.

 

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

 
| Asset retirement obligation, January 1, 2009 |   | $   | 2,483  |   |
|---------------------------------------------------|--------|-----|--------|--------|
| Less: obligation extinguished                     |   | (10 | )      |
| Add: additions on leased locations                |   | 9   |   |
| Add: accretion expense                            |   | 78  |   |
| Asset retirement obligation, June 30, 2009   |   | $   | 2,560  |   |

 

**Note 4:   Intangible Assets**

 

Intangible assets consist of the acquired value of customerrelationships, existing contracts to purchase, gather and sell natural gas andother NGLs and compression contracts, which do not have significant residualvalue. The customer relationships and the contracts are being amortized overtheir estimated lives of ten years. We review intangible assets for impairmentwhenever events or circumstances indicate that the carrying amounts may not berecoverable. If such a review should indicate that the carrying amount ofintangible assets is not recoverable, we reduce the carrying amount of suchassets to fair value based on the discounted probable cash flows of theintangible assets. No impairments of intangible assets were recorded during thethree and six months ended June 30, 2009 or 2008.

 

Intangible assets consisted of the following for the periods indicated:

 
| ** **                    | ** ** | **As of**         | ** ** | **As of**             | ** ** |
|-------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                    | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Gas sales contracts           |       | $                 | 32,564     |                  | $          | 32,564 |   |
| Compression contracts         |       | 18,515            |       | 18,515                |       |
| Customer relationships        |       | 10,492            |       | 10,492                |       |
|                          |       | 61,571            |       | 61,571                |       |
| Less accumulated amortization |       | 23,869            |       | 20,791                |       |
| Intangible assets, net        |       | $                 | 37,702     |                  | $          | 40,780 |   |

 

During each of the three months ended June 30, 2009 and 2008, werecorded $1,540 of amortization expense. During each of the six months ended June 30, 2009 and 2008, werecorded $3,079 of amortization expense. Estimated aggregate amortization expense for the remainder of 2009 is$3,080 and $6,157 for each of the four succeeding fiscal years from 2010through 2013 and a total of $9,994 for all years thereafter.

 

**Note 5: Derivatives**

 

***InterestRate Swap***

 

Hiland Partners is subject tointerest rate risk on its credit facility and has entered into an interest rateswap to reduce this risk. Hiland Partners entered into a one year interest rateswap agreement with its counterparty on October 7, 2008 for the periodfrom January 2009 through December 2009 at a rate of 2.245% on anotional amount of $100.0 million. The swap fixes the one month LIBOR rateat 2.245% for the notional amount of debt outstanding over the term of the swapagreement.  During the three and sixmonths ended June 30, 2009, one month LIBOR interest rates were lower thanthe contracted fixed interest rate of 2.245%.

 

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Consequently, for the three and six months ended June 30,2009, Hiland Partners incurred additional interest expense of $462 and $905,respectively, upon monthly settlements of the interest rate swap agreement.

 

The following table provides information about Hiland Partners’interest rate swap at June 30, 2009 for the periods indicated:

 
| ** **                          | ** ** | ** **   | ** ** | ** **   | ** ** | **Fair Value**  | ** ** |
|-------------------------------------|------------|--------------|------------|--------------|------------|-----------------|------------|
| ** **                          | ** ** | **Notional** | ** ** | **Interest** | ** ** | **Asset**       | ** ** |
| **Description and Period**          | ** ** | **Amount**   | ** ** | **Rate**     | ** ** | **(Liability)** | ** ** |
| Interest Rate Swap                  |       |         |       |         |       |            |       |
| July 2009 - December 2009 |       | $            | 100,000    |         | 2.245      | %               | $          | (921 | ) |
|                                     |            |              |            |              |            |                 |            |  |  |

 

***CommoditySwaps***

 

Hiland Partners has entered intocertain derivative contracts that are classified as cash flow hedges inaccordance with SFAS 133 which relate to forecasted natural gas sales in2009 and 2010. Hiland Partners entered into these financial swap instruments tohedge forecasted natural gas sales against the variability in expected futurecash flows attributable to changes in commodity prices. Under these swapagreements with its counterparties, Hiland Partners receives a fixed price andpays a floating price based on certain indices for the relevant contract periodas the underlying natural gas is sold.

 

Hiland Partners formally documents all relationships between hedginginstruments and the items being hedged, including its risk management objectiveand strategy for undertaking the hedging transactions. This includes matchingthe natural gas futures, the “sold fixed for floating price” or “buy fixed forfloating price” contracts, to the forecasted transactions. Hiland Partnersassesses, both at the inception of the hedge and on an ongoing basis, whetherthe derivatives are highly effective in offsetting changes in the fair value ofhedged items. Highly effective is deemed to be a correlation range from 80% to125% of the change in cash flows of the derivative in offsetting the cash flowsof the hedged transaction. If it is determined that a derivative is not highlyeffective as a hedge or it has ceased to be a highly effective hedge, due tothe loss of correlation between changes in natural gas reference prices under ahedging instrument and actual natural gas prices, Hiland Partners willdiscontinue hedge accounting for the derivative and subsequent changes in fairvalue for the derivative will be recognized immediately into earnings. HilandPartners assesses effectiveness using regression analysis and ineffectivenessusing the dollar offset method.

 

Derivatives are recorded on our consolidated balance sheet as assets orliabilities at fair value. For derivatives qualifying as hedges, the effectiveportion 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. The ineffective portions ofqualifying derivatives are recognized in earnings as they occur. Actual amountsthat will be reclassified will vary as a result of future changes in prices.Hedge ineffectiveness is recorded in income while the hedge contract is openand may increase or decrease until settlement of the contract. Realized cashgains and losses on closed/settled instruments and hedge ineffectiveness arereflected in the contract month being hedged as an adjustment to our midstreamrevenue.

 

On June 26, 2009, Hiland Partners unwound (cash settled) a 2010coupled qualified hedge for a discounted net amount of $3,155 and entered intoa new cash flow swap agreement for the same underlying forecasted natural gassales which settle in the same monthly periods in 2010.  The coupled qualified hedge Hiland Partnerscash settled on June 26, 2009 consisted of a receipt of $4,499 from onecounterparty offset by a payment of $1,344 to another counterparty. Of the$4,499 cash received, $3,571 had previously been recognized as midstreamrevenues in 2008 as the hedge, at that time, did not qualify for hedgeaccounting. The net unrecognized loss of $416 has been recorded to accumulatedother comprehensive income and will be recorded as reductions in midstreamrevenues as the hedged transactions settle in 2010. Under the terms of the newderivative contract, Hiland Partners receives a fixed price of $5.08 and pays afloating CIG index price for the same relevant volumes and contract period asthe underlying natural gas is sold.

 

Presented in the table below is information related to Hiland Partners’derivatives for the indicated periods:

 
| ** **                                                                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                          | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                          | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net gains (losses) on closed/settled transactions reclassified  from (to) accumulated other comprehensive income    |       | $                      | 2,171      |                 | $          | (3,028 | ) | $ | 3,879 |   | $ | (5,083 | ) |
| Increases (decreases) in fair values of open derivatives  recorded to (from) accumulated other comprehensive income |       | $                      | (1,332     | )                    | $          | (7,737 | ) | $ | 950 |   | $ | (10,253 | ) |
| Unrealized non-cash gains (losses) on ineffective portions  of qualifying derivative transactions                   |       | $                      | (137       | )                    | $          | (22 | ) | $ | 247 |   | $ | (5 | ) |
| Unrealized non-cash gains on non-qualifying  derivatives                                                            |       | $                      | —     |                 | $          | (1,512 | ) | $ | — |   | $ | (1,930 | ) |

 

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At June 30, 2009, Hiland Partners’ accumulated other comprehensiveincome was $2,304. Of this amount, Hiland Partners anticipates $4,003 will bereclassified to earnings during the next twelve months and $(1,699) will bereclassified to earnings in subsequent periods.

 

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

 
| ** **                                       | ** ** | **As of**         | ** ** | **As of**             | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Fair value of derivative assets - current        |       | $                 | 6,188      |                  | $          | 6,851 |   |
| Fair value of derivative assets - long term      |       | 1,597             |       | 7,141                 |       |
| Fair value of derivative liabilities - current   |       | (921              | )          | (1,439                | )          |
| Fair value of derivative liabilities - long term |       | (147              | )          | —                |       |
| Net fair value of derivatives                    |       | $                 | 6,717      |                  | $          | 12,553 |   |

 

The terms of Hiland Partners’ derivative contracts currently extend asfar as December 2010. The counterparties to Hiland Partners’commodity-based derivative instruments are BP Energy Company and Bank ofOklahoma, N.A. The counterparty to Hiland Partners’ interest rate swap is WellsFargo Bank, N.A.

 

The following table provides information about Hiland Partners’commodity derivative instruments at June 30, 2009 for the periodsindicated:

 
| ** **                                         | ** ** | ** **  | ** ** | **Average**     | ** ** | ** **     | ** ** |
|----------------------------------------------------|------------|-------------|------------|-----------------|------------|----------------|------------|
| ** **                                         | ** ** | ** **  | ** ** | **Fixed**       | ** ** | **Fair Value** | ** ** |
| **Description  and Production Period**             | ** ** | **Volume**  | ** ** | **Price**       | ** ** | **Asset**      | ** ** |
| ** **                                         | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **     | ** ** |
| Natural Gas - Sold Fixed  for Floating Price Swaps |       |        |       |            |       |           |       |
| July 2009 -  June 2010                   |       | 2,136,000   |       | $               | 7.01       |           | $          | 6,188 |   |
| July 2010 -  December 2010               |       | 1,068,000   |       | $               | 6.73       |           | 1,450      |   |
|                                               |       |        |       |            |       | $              | 7,638      |   |

 

**Note 6:   Fair Value Measurements**

 

We adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”)beginning in the first quarter of 2008. We adopted FSP 157-2 for nonfinancial assets and nonfinancialliabilities measured at fair value, except those that are recognized ordisclosed on a recurring basis (at least annually) effective January 1,2009, which applies to nonfinancial assets and liabilities measured at fairvalue in a business combination; impaired properties, plants and equipment;intangible assets and goodwill; and initial recognition of asset retirementobligations and restructuring costs for which we use fair value. SFAS 157defines fair value as the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date, establishes a framework for measuring fair value inGAAP such as fair value hierarchy used to classify the source of informationused in fair value measurements (i.e., market based or non-market based) andexpands disclosure about fair value measurements based on their level in thehierarchy.  SFAS 157 establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring fair value.SFAS 157’s hierarchy defines three levels of inputs that may be used to measurefair value. Level 1 refers to assets that have observable market prices, level2 assets do not have an “observable price” but do have inputs that are based onsuch prices in which components have observable data points and level 3 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 133 requires derivatives and other financial instruments bemeasured at fair value at initial recognition and for all subsequentperiods.  We use the fair valuemethodology outlined in SFAS 157 to value assets and liabilities for ouroutstanding fixed price cash flow swap derivative contracts. Valuations of ournatural gas derivative contracts are based on published forward price curvesfor natural gas and, as such, are defined as Level 2 fair value hierarchyassets and liabilities. We value our interest rate-based derivative on acomparative mark-to-market value received from our counterparty and, as such,is defined as Level 3. The following 

 

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table representsthe fair value hierarchy for Hiland Partners’ assets and liabilities measuredat fair value on a recurring basis at June 30, 2009:

 
| ** **                               | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Commodity - based derivative assets      |       | $           | —     |        | $          | 7,785       |       | $         | —     |   | $ | 7,785 |   |
| Commodity - based derivative liabilities |       | —      |       | (147        | )          | —      |       | (147      | )          |
| Interest - based derivative liabilities  |       | —      |       | —      |       | (921        | )          | (921      | )          |
| Total                                    |       | $           | —     |        | $          | 7,638       |       | $         | (921       | ) | $ | 6,717 |   |

 

The following table provides a summary of changes inthe fair value of Hiland Partners’ Level 3 interest rate-based derivatives forthe six months ended June 30, 2009:

** **
| Balance, January 1, 2009                    |   | $    | (1,439 | ) |
|--------------------------------------------------|--------|------|--------|---|
| Cash settlements from other comprehensive income |   | 906  |   |
| Change in fair value of derivative               |   | (388 | )      |
| Balance, June 30, 2009                      |   | $    | (921   | ) |

 

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

 

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

 

**Note 7: Long-TermDebt**

 

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

 
| ** **                                | ** ** | **As of**         | ** ** | **As of**             | ** ** |
|-------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Hiland Partners-revolving credit facility |       | $                 | 261,064    |                  | $          | 252,064 |   |
| Hiland Holdings-revolving credit facility |       | 1,205             |       | 705                   |       |
| Capital lease obligations                 |       | 4,701             |       | 5,051                 |       |
|                                      |       | 266,970           |       | 257,820               |       |
| Less current portion:                     |       |              |       |                  |       |
| Capital lease obligations                 |       | 648               |       | 649                   |       |
| Hiland Holdings-revolving credit facility |       | 1,205             |       | 705                   |       |
| Long-term debt                            |       | $                 | 265,117    |                  | $          | 256,466 |   |

 

***HilandPartners Credit Facility***

 

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

 

In addition, Hiland Partners senior secured revolving credit facilityprovides for an accordion feature, which permits Hiland Partners, if certainconditions are met, to increase the size of the Acquisition Facility by up to$50 million and allows for the issuance 

 

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of letters ofcredit of up to $15 million in the aggregate. The credit facility willmature in May 2011. At that time, the agreement will terminate and alloutstanding amounts thereunder will be due and payable.

 

Due to lower natural gas and NGL prices and the impact of reduceddrilling activity on Hiland Partners’ current and projected throughput volumes,Hiland Partners believes that cash generated from operations will decrease forthe remainder of 2009 relative to comparable periods in 2008.  Hiland Partners’ senior secured revolvingcredit facility requires Hiland Partners to meet certain financial tests,including a maximum consolidated funded debt to EBITDA covenant ratio of4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscalquarters following the quarter in which such permitted acquisition or capitalexpenditure occurs.  Hiland Partners metthe permitted capital expenditure requirements for the four quarter periodended March 31, 2009 and elected to increase the ratio to 4.75:1.0 on March 31,2009 for the quarters ended March 31, 2009, June 30, 2009 and September 30,2009.  During this step-up period, theapplicable margin with respect to loans under the credit facility increases by35 basis points per annum and the unused commitment fee increases by 12.5 basispoints per annum. The ratio will revert back to 4.0:1.0 for the quarter ended December 31,2009.  If commodity prices do notsignificantly improve above the current forward prices for 2009, thePartnership could be in violation of the maximum consolidated funded debt toEBITDA covenant ratio as early as September 30, 2009, unless this ratio isamended, Hiland Partners receives an infusion of equity capital, HilandPartners’ debt is restructured or Hiland Partners is able to monetize “in-the-money”hedge positions.  Management iscontinuing extensive discussions with certain lenders under the credit facilityas to ways to address a potential covenant violation. While no potentialsolution has been agreed to, Hiland Partners expects that any solution willrequire the assessment of fees and increased rates, the infusion of additionalequity capital or the incurrence of subordinated indebtedness by HilandPartners and the suspension of distributions for a certain period of time.There can be no assurance that any such agreement will be reached with thelenders, that any required equity or debt financing will be available to HilandPartners, or that Hiland Partners’ hedge positions will be “in-the-money.”

 

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

 

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

 

Indebtedness under Hiland Partners’ credit facility will bear interest,at its option, at either (i) an Alternate Base Rate plus an applicablemargin ranging from 50 to 125 basis points per annum or (ii) LIBOR plus anapplicable margin ranging from 150 to 225 basis points per annum based on itsratio of consolidated funded debt to EBITDA. The Alternate Base Rate is a rateper annum equal to the greatest of (a) the Prime Rate in effect on suchday, (b) the base CD rate in effect on such day plus 1.50% and (c) theFederal Funds effective rate in effect on such day plus  1/2 of 1%. Hiland Partners has elected forthe indebtedness to bear interest at LIBOR plus the applicable margin. A letterof credit fee will be payable for the aggregate amount of letters of creditissued under the credit facility at a percentage per annum equal to 1.0%. Anunused commitment fee ranging from 25 to 50 basis points per annum based onHiland Partners’ ratio of consolidated funded debt to EBITDA will be payable onthe unused portion of the credit facility. During the step-up period, theapplicable margin with respect to loans under the credit facility will beincreased by 35 basis points per annum and the unused commitment fee will beincreased by 12.5 basis points per annum. At June 30, 2009, the interestrate on outstanding borrowings from Hiland Partners’ credit facility was 2.92%.

 

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

 

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

 

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

 

The credit facility limits distributions to Hiland Partners’unitholders to available cash, as defined by the agreement, and borrowings tofund such distributions are only permitted under the revolving working capitalfacility. The revolving working capital 

 

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facility issubject to an annual “clean-down” period of 15 consecutive days in which theamount outstanding under the revolving working capital facility is reduced tozero.

 

As of June 30, 2009, Hiland Partners had $261.1 millionoutstanding under this credit facility and was in compliance with its financialcovenants.  Hiland Partners’ EBITDA tointerest expense ratio was 4.95 to 1.0 and its consolidated funded debt toEBITDA ratio was 4.40 to 1.0.

 

***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 senior secured credit facility. Pursuant to theterms of the agreement, we elected to reduce the commitment level on the creditfacility to $10.0 million effective May 15, 2009 and we elected to furtherreduce the commitment level on the credit facility to $3.0 million on August 7,2009.  Concurrently with the reduction ofthe commitment level to $3.0 million, the existing lenders under the creditfacility assigned their interests in the facility to The Security National Bankof Enid and we entered into a first amended and restated senior secured creditagreement with The Security National Bank of Enid.  The credit facility is secured by all of ourownership interests in Hiland Partners and its general partner, other than the2% general partner interest and the incentive distribution rights.  The credit facility will mature on December31, 2009, at which time all outstanding amounts thereunder become due andpayable.

 

Indebtedness underthe credit facility bears interest at the prime rate plus 1% per annum, but inno event less than 5% per annum, to be adjusted as changes occur in the primerate.  At August 7, 2009, the interestrate on outstanding borrowings from our credit facility was 5.0%.

 

The creditfacility contains several covenants that, among other things, require themaintenance of a debt-to-worth ratio and require financial reports to besubmitted periodically.  The creditfacility also contains various covenants that limit, among other things,subject to certain exceptions, our ability to grant liens, enter intoagreements restricting our ability to grant liens on our assets or amend thecredit facility, make certain loans, acquisitions and investments or enter intoa merger, consolidation or sale of assets.

 

The amount we mayborrow under the credit facility is limited to the lesser of: (i) 50% of thesum of the value of the Hiland Partners common and subordinated units and (ii)the maximum available amount of the credit facility (currently $3.0million).  For purposes of thiscalculation, the value of (i) the Hiland Partners common units on any dateshall be the closing price for such units as reflected on the NASDAQ NationalMarket on any date and (ii) the Hiland Partners subordinated units on any dateshall be deemed to equal 85% of the value of the Hiland Partners common unitson such date.  At August 7, 2009, theborrowing base was $3.0 million.

 

As of August 7,2009, we had $2.5 million outstanding under this credit facility and were incompliance with our debt-to-worth ratio covenant. As of June 30, 2009, wehad $1.2 million outstanding under our prior credit facility and were incompliance with our financial covenants. The outstanding $1.2 million atJune 30, 2009, which now matures on December 31, 2009, is included inaccrued liabilities and other in the balance sheet.

 

***Capital Lease Obligations***

 

Hiland Partners is obligated under two separate capital leaseagreements entered into with respect to its Bakken and Badlands gatheringsystems in the third quarter of 2007. Under the terms of a capital leaseagreement for a rail loading facility and an associated products pipeline atits Bakken gathering system, Hiland Partners is repaying 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 

 

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commencing fromthe inception date of the lease. Hiland Partners also incurred a capital leaseobligation to a counterparty for the aid to construct several electricsubstations at its Badlands gathering system which, by agreement, is beingrepaid in equal monthly installments over a period of five years.

 

During the three and six months ended June 30, 2009, HilandPartners made principal payments of $185 and $350, respectively, on the abovedescribed capital lease obligations.  Thecurrent portion of the capital lease obligations presented in the table above isincluded in accrued liabilities and other in the balance sheet.

 

**Note 8:  Share-BasedCompensation**

 

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

 

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

 

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

 

As provided for in the long-term incentiveplan, each non-employee board member of Hiland Partners GP Holdings, LLC oneach anniversary date of the initial reward is entitled to receive anadditional 1,000 restricted common units. We issued no restricted units duringthe three and six months ended June 30, 2009. Non-cash unit basedcompensation expense related to restricted units issued is to be recognizedover their respective four-year vesting period on the graded vestingattribution method. As of June 30, 2009, we have 16,500 unvested restrictedunits outstanding with a weighted average fair value at grant date of $22.52per unit.

 

We recorded non-cash compensation expense related to the restrictedunits of $36 and $72 for the three and six months ended June 30, 2009,respectively, and $38 and $77 for the three and six months ended June 30,2008, respectively. We will record additional non-cash unit based compensationexpense of $145 over the next four years.

 

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

 

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

 

Hiland Partners GP, LLC’s board of directors or compensation committeemay, in their discretion, terminate, suspend or discontinue the long-termincentive plan at any time with respect to any units for which a grant has notyet been made. Hiland Partners GP, LLC’s board of directors or its compensationcommittee also has the right to alter or amend the long-term incentive plan orany part of the plan from time to time, including increasing the number ofunits that may be granted, subject to unitholder approval if required by theexchange upon which the common units are listed at that time. No change in anyoutstanding grant may be made, however, that would materially impair the rightsof the participant without the consent of the participant. Under the unitoption grant agreement, granted options of common units vest and becomeexercisable in one-third increments on the anniversary of the grant date overthree years. Vested options are exercisable within the option’s contractuallife of ten years after the grant date. Restricted common units granted vestand become exercisable in one-fourth increments on the anniversary of the grantdate over four years. A restricted unit is a common unit that is subject toforfeiture, and upon vesting, the grantee receives a common unit that is notsubject to 

 

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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 Hiland Partners’ general partner’s board of directors and (ii) thedistributions held in trust, if applicable, related to the vested units.

 

*Phantom Units. * On June 19, 2009, 2,500 phantom unitsawarded to our Chief Executive Officer in June 2007 vested and wereconverted to common units. On April 1, 2009, our former Chief CommercialOfficer retired and forfeited 3,750 phantom units.

 

The following table summarizes information aboutHiland Partners’ phantom units for the six months ended June 30, 2009:

 
| ** **                        | ** ** | ** ** | ** ** | **Weighted**   | ** ** |
|-----------------------------------|------------|------------|------------|----------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Average**    | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Per Unit**   | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Phantom Units**                 | ** ** | **Units**  | ** ** | **Date  ($)**  | ** ** |
| Unvested at January 1,  2009 |       | 50,794     |       | $              | 47.74      |   |
| Granted                           |       | —     |       |           |       |
| Vested and converted              |       | (5,625     | )          | $              | 51.65      |   |
| Forfeited                         |       | (5,050     | )          | $              | 45.11      |   |
| Unvested at June 30,  2009   |       | 40,119     |       | $              | 47.53      |   |

 

During the three and six months ended June 30,2009, Hiland Partners incurred non-cash unit based compensation expense of $219and $463, respectively, related to phantom units. During the three and sixmonths ended June 30, 2008, Hiland Partners incurred non-cash unit basedcompensation expense of $301 and $580, respectively, related to phantom units.Hiland Partners will recognize additional expense of $992 over the next fouryears, and the additional expense is to be recognized over a weighted averageperiod of 2.5 years.

 

*Restricted Units.*   HilandPartners issued no restricted units during the three and six months ended June 30,2009.  On April 1, 2009, our formerChief Commercial Officer retired and forfeited 1,500 restricted units.  The following table summarizes informationabout Hiland Partners restricted units for the six months ended June 30,2009.

 
| ** **                       | ** ** | ** ** | ** ** | **Weighted**   | ** ** |
|----------------------------------|------------|------------|------------|----------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Average**    | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Fair Value** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Per Unit**   | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **At Grant**   | ** ** |
| **Restricted Units**             | ** ** | **Units**  | ** ** | **Date ($)**   | ** ** |
| Unvested at January 1, 2009 |       | 18,500     |       | $              | 48.73      |   |
| Granted                          |       | —     |       |           |       |
| Vested                           |       | —     |       |           |       |
| Forfeited                        |       | (4,250     | )          | $              | 47.56      |   |
| Unvested at June 30, 2009   |       | 14,250     |       | $              | 49.08      |   |

 

Non-cash unit based compensation expense related toHiland Partners restricted units was $62 and $137 for the three and six monthsended June 30, 2009, respectively, and was $83 and 167 for the three andsix months ended June 30, 2008, respectively.  As of June 30, 2009, there was $212 oftotal unrecognized cost related to Hiland Partners unvested restricted units.This cost is to be recognized over a weighted average period of 2.0 years.

 

*Unit Options.*   At June 30,2009, all common unit options awarded by Hiland Partners have vested.  The weighted average exercise price of 33,336outstanding exercisable common unit options at June 30, 2009 is $37.79 perunit, and such common units have a weighted average remaining contractual termof 6.4 years.  Non-cash unit basedcompensation expense related to the unit options was insignificant for thethree and six months ended June 30, 2009, respectively.

 

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**Note 9: Commitments and Contingencies**

 

We maintain a defined contribution retirement plan for our employeesunder which we make discretionary contributions to the plan based on apercentage of eligible employees’ compensation. Contributions to the plan are5.0% of eligible employees’ compensation and resulted in expense for the threemonths ended June 30, 2009 and 2008 of $101 and $80, respectively and forthe six months ended June 30, 2009 and 2008 was $190 and $155,respectively.

 

We maintain our health and workers’ compensation insurance throughthird-party providers. Property and general liability insurance is alsomaintained through third-party providers with a $100 deductible on each policy.

 

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

 

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

 

Hiland Partners leases certain equipment, vehicles and facilities underoperating leases, most of which contain annual renewal options. We and HilandPartners also lease office space from a related entity. See Note 11 “RelatedParty Transactions.” Under these lease agreements, rent expense was $751 and$636, respectively, for the three months ended June 30, 2009 and 2008,respectively and $1,594 and $1,252 for the six months ended June 30, 2009and 2008, respectively.

 

Three putative unitholder class action lawsuits have been filedrelating to the Hiland Partners Merger and the Hiland Holdings Merger.  These lawsuits are as follows: (i) *Robert Pasternack v. Hiland Partners, LP et al.*, In theCourt of Chancery of the State of Delaware, Civil Action No. 4397-VCS; (ii) *Andrew Jones v. Hiland Partners, LP et al.*, In the Court ofChancery of the State of Delaware, Civil Action No. 4558-VCS; and (iii) *Arthur G. Rosenberg v. Hiland Partners, LP et al.*, In theDistrict Court of Garfield County, State of Oklahoma, Case No. C3-09-211-02.  The lawsuits name as defendants thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and the members of the board of directors of each of thePartnership and Hiland Partners.   Thelawsuits challenge both the Hiland Partners Merger and the Hiland HoldingsMerger.  The lawsuits allege claims ofbreach of the Partnership Agreement and breach of fiduciary duty on behalf of (i) apurported class of common unitholders of the Partnership and (ii) apurported class of our common unitholders of Hiland Partners.

 

On July 10, 2009, the court in which the Oklahoma case is pendinggranted our motion to stay the Oklahoma lawsuit in favor of the Delawarelawsuits.   On July 31, 2009, theplaintiff in the first-filed Delaware case (*Pasternack*)filed an Amended Class Action Complaint and a motion to enjoin themergers.   This Amended Class ActionComplaint alleges, among other things, that (i) the original considerationand revised consideration offered by the Hamm Parties is unfair and inadequate,(ii) the members of the conflicts committees of the general partner ofeach of the Partnership and Hiland Partners that were charged with reviewingthe proposals and making a recommendation to each committee’s respective boardof directors lacked any meaningful independence, (iii) the defendantsacted in bad faith in recommending and approving the Hiland Partners Merger orthe Hiland Holdings Merger, and (iv) the disclosures in the PreliminaryProxy Statement filed by the Partnership and Hiland Partners are materiallymisleading.   The *Pasternack*plaintiffseeks to preliminarily enjoin the defendants from proceeding with orconsummating the mergers and seeks an order requiring defendants to supplementthe Preliminary Proxy Statement with certain information.  We cannot predict the outcome of theselawsuits, or others, nor can we predict the amount of time and expense thatwill be required to resolve the lawsuits.

 

Additional information concerning these lawsuits may be found in thePreliminary Proxy Statement filed by the Partnership and Hiland Partners and,when filed, in the definitive joint proxy statement.

 

**Note 10: Significant Customers andSuppliers**

 

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

 
| ** ** | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2009**                                      | ** ** | **2008**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Customer 1 |       | 23                                            | %          | 22                                          | %          | 20 | % | 21 | % |
| Customer 2 |       | 12                                            | %          | 1                                           | %          | 10 | % | 0 | % |
| Customer 3 |       | 12                                            | %          | 9                                           | %          | 15 | % | 9 | % |
| Customer 4 |       | 12                                            | %          | 9                                           | %          | 8 | % | 14 | % |
| Customer 5 |       | 10                                            | %          | 14                                          | %          | 11 | % | 11 | % |
| Customer 6 |       | 5                                             | %          | 15                                          | %          | 5 | % | 15 | % |
| Customer 7 |       | 3                                             | %          | 10                                          | %          | 3 | % | 8 | % |

 

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Customer 1 above is SemStream, L.P., a subsidiary of SemGroup, L.P.,who filed a voluntary petition for reorganization under Chapter 11 of the U.S.Bankruptcy Code on July 22, 2008. In March 2009, Hiland Partners received a good faith deposit fromSemStream, L.P. for $3,000 in lieu of renewing a letter of credit to ourbenefit.  The $3,000 deposit received isincluded in accrued liabilities and other in the balance sheet.

 

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

 
| ** **                       | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                      | ** ** | **2008**                                    | ** ** | **2009** | ** ** | **2008** | ** ** |
| Supplier 1 (affiliated  company) |       | 40                                            | %          | 42                                          | %          | 42 | % | 40 | % |
| Supplier 2                       |       | 20                                            | %          | 16                                          | %          | 18 | % | 15 | % |
| Supplier 3                       |       | 17                                            | %          | 18                                          | %          | 16 | % | 18 | % |

 

**Note 11: Related Party Transactions**

 

Hiland Partners purchases natural gas and NGLs from affiliatedcompanies. Purchases of product from affiliates totaled $10,353 and $36,882 forthe three months ended June 30, 2009 and 2008, respectively and totaled$23,798 and $63,049 for the six months ended June 30, 2009 and 2008,respectively. Hiland Partners also sells natural gas and NGLs to affiliatedcompanies. Sales of product to affiliates totaled $867 and $2,022 for the threemonths ended June 30, 2009 and 2008, respectively and totaled $1,899 and$3,043 for the six months ended June 30, 2009 and 2008, respectively.Compression revenues from affiliates were $1,205 and $2,410 for each of thethree and six months ended June 30, 2009 and 2008, respectively.

 

Accounts receivable - affiliates of $2,745 at June 30, 2009include $2,649 from one affiliate for midstream sales. Accounts receivable -affiliates of $2,346 at December 31, 2008, includes $2,083 from oneaffiliate for midstream sales.

 

Accounts payable - affiliates of $5,236 at June 30, 2009 include$4,018 due to one affiliate for midstream purchases. Accounts payable -affiliates of $7,823 at December 31, 2008 include $6,682 payable to thesame affiliate for midstream purchases.

 

Hiland Partners utilizes affiliated companies to provide services toits plants and pipelines and certain administrative services. The totalexpenditures to these companies were $82 and $111 during the three months endedJune 30, 2009 and 2008, respectively and were $256 and $263 during the sixmonths ended June 30, 2009 and 2008, respectively.

 

We and Hiland Partners lease office space under operating leasesdirectly or indirectly from an affiliate. Rent expense associated with theseleases totaled $41 and $37 for the three months ended June 30, 2009 and2008, respectively and totaled $80 and $75 for the six months ended June 30,2009 and 2008, respectively.

 

**Note 12: Reportable Segments**

 

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

 

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

 

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

 

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

 

Midstream assets totaled $398,812 at June 30, 2009. Assetsattributable to compression operations totaled $23,773. All but $27 of thetotal capital expenditures of $19,189 for the six months ended June 30,2009 was attributable to midstream operations. All but $24 of the total capitalexpenditures of $18,368 for the six months ended June 30, 2008 wasattributable to midstream operations.

 

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The tables below present information for the reportable segments forthe three and six months ended June 30, 2009 and 2008.

 
| ** **                                                               | ** ** | **For the Three Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                                     | ** ** | **2008** | ** ** |
| ** **                                                               | ** ** | **Midstream**                                | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **Segment**                                  | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
|                                                                     | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                 |       | $                                            | 48,874     |   | $ | 1,205 |   | $ | 50,079 |   | $ | 114,236 |   | $ | 1,205 |   | $ | 115,441 |   |
| Operating costs and  expenses:                                           |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Midstream purchases  (exclusive of items shown separately below)         |       | 26,999                                       |       | — |   | 26,999 |   | 88,073 |   | — |   | 88,073 |   |
| Operations and maintenance                                               |       | 7,575                                        |       | 210 |   | 7,785 |   | 7,271 |   | 280 |   | 7,551 |   |
| Depreciation and  amortization                                           |       | 9,927                                        |       | 897 |   | 10,824 |   | 8,561 |   | 895 |   | 9,456 |   |
| Property impairments                                                     |       | —                                       |       | — |   | — |   | — |   | — |   | — |   |
| Bad debt                                                                 |       | —                                       |       | — |   | — |   | 8,103 |   | — |   | 8,103 |   |
| General and administrative                                               |       | 4,502                                        |       | 104 |   | 4,606 |   | 2,314 |   | 19 |   | 2,333 |   |
| Total operating costs and  expenses                                      |       | 49,003                                       |       | 1,211 |   | 50,214 |   | 114,322 |   | 1,194 |   | 115,516 |   |
| Operating (loss) income                                                  |       | $                                            | (129       | ) | $ | (6 | ) | (135 | ) | $ | (86 | ) | $ | 11 |   | (75 | ) |
| Other income (expense):                                                  |       |                                         |       |   |   |   |   |   |   |   |   |   |   |
| Interest and other income                                                |       |                                         |       |   |   | 68 |   |   |   |   |   | 73 |   |
| Amortization of deferred  loan costs                                     |       |                                         |       |   |   | (172 | ) |   |   |   |   | (168 | ) |
| Interest expense                                                         |       |                                         |       |   |   | (2,691 | ) |   |   |   |   | (3,130 | ) |
| Net loss                                                                 |       |                                         |       |   |   | (2,930 | ) |   |   |   |   | (3,300 | ) |
| Less: Noncontrolling  partners’ interest in loss of Hiland Partners |       |                                         |       |   |   | (395 | ) |   |   |   |   | (2,192 | ) |
| Limited partners’ interest  in net loss                             |       |                                         |       |   |   | $ | (2,535 | ) |   |   |   |   | $ | (1,108 | ) |

 
| ** **                                                               | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                           | ** ** | **2008** | ** ** |
| ** **                                                               | ** ** | **Midstream**                      | ** ** | **Compression** | ** ** | ** ** | ** ** | **Midstream** | ** ** | **Compression** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **Segment**                        | ** ** | **Segment** | ** ** | **Total** | ** ** | **Segment** | ** ** | **Segment** | ** ** | **Total** | ** ** |
|                                                                     | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                 |       | $                                  | 100,017    |   | $ | 2,410 |   | $ | 102,427 |   | $ | 204,510 |   | $ | 2,410 |   | $ | 206,920 |   |
| Operating costs and  expenses:                                           |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Midstream purchases  (exclusive of items shown separately below)         |       | 58,215                             |       | — |   | 58,215 |   | 156,691 |   | — |   | 156,691 |   |
| Operations and maintenance                                               |       | 15,053                             |       | 427 |   | 15,480 |   | 13,811 |   | 509 |   | 14,320 |   |
| Depreciation and  amortization                                           |       | 19,287                             |       | 1,795 |   | 21,082 |   | 16,881 |   | 1,790 |   | 18,671 |   |
| Property impairments                                                     |       | 950                                |       | — |   | 950 |   | — |   | — |   | — |   |
| Bad debt                                                                 |       | —                             |       | — |   | — |   | 8,103 |   | — |   | 8,103 |   |
| General and administrative                                               |       | 8,234                              |       | 199 |   | 8,433 |   | 4,969 |   | 49 |   | 5,018 |   |
| Total operating costs and  expenses                                      |       | 101,739                            |       | 2,421 |   | 104,160 |   | 200,455 |   | 2,348 |   | 202,803 |   |
| Operating income (loss)                                                  |       | $                                  | (1,722     | ) | $ | (11 | ) | (1,733 | ) | $ | 4,055 |   | $ | 62 |   | 4,117 |   |
| Other income (expense):                                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest and other income                                                |       |                               |       |   |   | 81 |   |   |   |   |   | 177 |   |
| Amortization of deferred  loan costs                                     |       |                               |       |   |   | (343 | ) |   |   |   |   | (324 | ) |
| Interest expense                                                         |       |                               |       |   |   | (5,049 | ) |   |   |   |   | (6,636 | ) |
| Net loss                                                                 |       |                               |       |   |   | (7,044 | ) |   |   |   |   | (2,666 | ) |
| Less: Noncontrolling  partners’ interest in loss of Hiland Partners |       |                               |       |   |   | (1,610 | ) |   |   |   |   | (2,398 | ) |
| Limited partners’ interest  in net loss                             |       |                               |       |   |   | $ | (5,434 | ) |   |   |   |   | $ | (268 | ) |

 

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

 

The computation of basic net income (loss) per limited partners’ unitis based on the weighted-average number of common units outstanding during theperiod. The computation of diluted net income (loss) per unit further assumesthe dilutive effect of restricted units. Net income (loss) per unit applicableto limited partners is computed by dividing net income (loss) applicable tolimited partners by the weighted-average number of limited partnership unitsoutstanding. The following is a reconciliation of the limited partner unitsused in the calculations of net income (loss) per limited partner unit—basicand net income (loss) per limited partner unit—diluted assuming dilution forthe three and six months ended June 30, 2009 and 2008:

 
|                                                            |   | **For the Three Months Ended June 30,**              |       |
|-----------------------------------------------------------------|--------|-----------------------------------------------------------|------------|
|                                                            |   | **2009**                                                  | ** ** | **2008** |   |
|                                                            |   | **Loss  Attributable  to Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** | **Loss  Attributable  to Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** |   |
| Loss per limited partner  unit-basic:                           |   |                                                      |       |   |   |   |   |   |   |   |   |   |   |
| Loss attributable to  limited partners                          |   | $                                                         | (2,535     | ) |   |   | $ | (0.12 | ) | $ | (1,108 | ) |   |   | $ | (0.05 | ) |
| Weighted average limited  partner units outstanding             |   |                                                      |       | 21,607,500 |   |   |   |   |   | 21,603,000 |   |   |   |
| Loss per limited partner  unit-diluted: Restricted units        |   |                                                      |       | — |   |   |   |   |   | — |   |   |   |
| Loss attributable to  limited partners plus assumed conversions |   | $                                                         | (2,535     | ) | 21,607,500 |   | $ | (0.12 | ) | $ | (1,108 | ) | 21,603,000 |   | $ | (0.05 | ) |

 
| ** **                                                      | ** ** | **For the Six Months Ended June 30,**             | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2009**                                               | ** ** | **2008** | ** ** |
| ** **                                                      | ** ** | **Loss  Available to  Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** | **Loss  Available to  Limited  Partners  (Numerator)** | ** ** | **Limited  Partner Units  (Denominator)** | ** ** | **Per Unit  Amount** | ** ** |
| Loss per limited partner  unit-basic:                           |       |                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Loss attributable to  limited partners                          |       | $                                                      | (5,434     | ) |   |   | $ | (0.25 | ) | $ | (268 | ) |   |   | $ | (0.01 | ) |
| Weighted average limited  partner units outstanding             |       |                                                   |       | 21,607,500 |   |   |   |   |   | 21,603,000 |   |   |   |
| Loss per limited partner  unit-diluted: Restricted units        |       |                                                   |       | — |   |   |   |   |   | — |   |   |   |
| Loss attributable to  limited partners plus assumed conversions |       | $                                                      | (5,434     | ) | 21,607,500 |   | $ | (0.25 | ) | $ | (268 | ) | 21,603,000 |   | $ | (0.01 | ) |

 

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For the three and six months ended June 30, 2009, approximately16,500 restricted units were excluded from the computation of diluted earningsattributable to limited partner units because the inclusion of such units wouldhave been anti-dilutive.

 

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

 

***Hiland Holdings***

 

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

 

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

 

We have suspended quarterly cash distributions beginning with the firstquarter distribution of 2009 and Hiland Partners has also suspended quarterlycash distributions on its common and subordinated units beginning with thefirst quarter distribution of 2009 due to the impact of lower commodity pricesand reduced drilling activity on Hiland Partners’ current and projectedthroughput volumes, midstream segment margins and cash flows combined withfuture required levels of capital expenditures and the outstanding indebtednessunder Hiland Partners’ senior secured revolving credit facility. Under theterms of the Hiland Partners partnership agreement, the Hiland Partners commonunits carry an arrearage of $0.90 per unit, representing the minimum quarterlydistribution to the Hiland Partners common units for the first two quarters of2009 that must be paid before Hiland Partners can make distributions to theHiland Partners subordinated units. All distributions paid by us to our commonunitholders from January 1, 2008 forward, including amounts paid toaffiliate owners, were as follows (in thousands, except per unit amounts):

 

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

 

***Hiland Partners***

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Hiland Partners has suspended quarterly cash distributions on itscommon and subordinated units beginning with the first quarter distribution of2009 due to the impact of lower commodity prices and reduced drilling activityon Hiland Partners’ current and projected throughput volumes, midstream segmentmargins and cash flows combined with future required levels of capitalexpenditures and the outstanding indebtedness under Hiland Partners’ seniorsecured revolving credit facility.  Underthe terms of the Hiland Partners partnership agreement, the Hiland Partnerscommon units carry an arrearage of $0.90 per unit, representing the minimumquarterly distribution to the Hiland Partners common units for the first twoquarters of 2009 that must be paid before Hiland Partners can makedistributions to the Hiland Partners subordinated units.  We own 3,060,000 of the Hiland Partnerssubordinated units which will not receive a cash distribution until thedistribution arrearage to the Hiland Partners common units is paid. Presentedbelow are cash distributions to the Hiland Partners common and subordinatedunitholders, including amounts to affiliate owners and regular and incentivedistributions to Hiland Partners GP, LLC paid by Hiland Partners from January 1,2008 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** | ** ** |
| 02/14/08         |       | $                 | 0.7950     |       | $          | 4,169            |       | $                   | 3,243      |           | $          | 182              |       | $ | 1,492 |   | $ | 9,086 |   |
| 05/14/08         |       | 0.8275            |       | 4,364      |       | 3,376            |       | 194                 |       | 1,789          |       | 9,723            |       |
| 08/14/08         |       | 0.8625            |       | 5,446      |       | 2,639            |       | 208                 |       | 2,107          |       | 10,400           |       |
| 11/14/08         |       | 0.8800            |       | 5,574      |       | 2,694            |       | 214                 |       | 2,268          |       | 10,750           |       |
| 02/13/09         |       | 0.4500            |       | 2,849      |       | 1,377            |       | 86                  |       | —         |       | 4,312            |       |
|             |       | $                 | 3.8150     |       | $          | 22,402           |       | $                   | 13,329     |           | $          | 884              |       | $ | 7,656 |   | $ | 44,271 |   |

 

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

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

 

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**Note15:   Supplemental Information**

 

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

 

**HILAND HOLDINGS GP, LP**

**Balance Sheets**

**(inthousands, except unit amounts)**

 

| ** **                                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                    |       |              |       |                  |       |
| **Current assets:**                                           |       |              |       |                  |       |
| Cash and cash equivalents                                     |       | $                 | 159        |                  | $          | 561 |   |
| Accounts receivable - affiliates                              |       | —            |       | 2                     |       |
| Other current assets                                          |       | 265               |       | 351                   |       |
| Total current assets                                          |       | 424               |       | 914                   |       |
|                                                          |       |              |       |                  |       |
| Investment in subsidiary                                      |       | (569              | )          | 4,195                 |       |
| Property and equipment, net                                   |       | 3,080             |       | 3,304                 |       |
| Intangibles, net                                              |       | 4,789             |       | 5,138                 |       |
| Other assets, net                                             |       | 22                |       | 66                    |       |
| **Total assets**                                              |       | $                 | 7,746      |                  | $          | 13,617 |   |
|                                                          |       |              |       |                  |       |
| **LIABILITIES AND PARTNERS’ EQUITY**                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| **Current liabilities:**                                      |       |              |       |                  |       |
| Accounts payable                                              |       | $                 | 1,334      |                  | $          | 363 |   |
| Accounts payable - affiliates                                 |       | 345               |       | 163                   |       |
| Other current liabilities                                     |       | 1,205             |       | 705                   |       |
| Total current liabilities                                     |       | 2,884             |       | 1,231                 |       |
|                                                          |       |              |       |                  |       |
| Long-term debt                                                |       |              |       |                  |       |
|                                                          |       |              |       |                  |       |
| **Partners’ equity**                                     |       |              |       |                  |       |
| Common unitholders (21,607,500 units issued and  outstanding) |       | 4,862             |       | 12,386                |       |
| **Total partners’ equity**                               |       | 4,862             |       | 12,386                |       |
|                                                          |       |              |       |                  |       |
| **Total liabilities and partners’  equity**              |       | $                 | 7,746      |                  | $          | 13,617 |   |

 

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**HILANDHOLDINGS GP, LP**

**Statementsof Operations**

**Forthe Three and Six Months Ended (Unaudited, in thousands)**

 

| ** **                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                              | ** ** | **2009**                             | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Operating costs and expenses:**       | ** ** | ** **                           | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Depreciation and amortization           |       | $                                    | (286       | )                                  | $          | (286 | ) | $ | (573 | ) | $ | (573 | ) |
| General and administrative              |       | (1,667                               | )          | (470                               | )          | (2,554 | ) | (853 | ) |
| Operating loss                          |       | (1,953                               | )          | (756                               | )          | (3,127 | ) | (1,426 | ) |
| **Other income (expense):**             |       |                                 |       |                               |       |   |   |   |   |
| Equity in (loss) earnings of affiliates |       | (553                                 | )          | (317                               | )          | (2,252 | ) | 1,216 |   |
| Interest and other income               |       | —                               |       | 3                                  |       | 1 |   | 6 |   |
| Amortization of deferred loan costs     |       | (22                                  | )          | (23                                | )          | (44 | ) | (45 | ) |
| Interest expense                        |       | (7                                   | )          | (15                                | )          | (12 | ) | (19 | ) |
| Other income (expense), net             |       | (582                                 | )          | (352                               | )          | (2,307 | ) | 1,158 |   |
| **Net (loss) income**                   |       | $                                    | (2,535     | )                                  | $          | (1,108 | ) | $ | (5,434 | ) | $ | (268 | ) |

 

**HILANDHOLDINGS GP, LP**

**Statementsof Cash Flows**

**Forthe Six Months Ended (Unaudited, in thousands)**

 

| ** **                                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                   | ** ** | **2009**                           | ** ** | **2008** | ** ** |
| **Cash flows from operating  activities:**                                                   |       |                               |       |   |   |
| Net (loss) income                                                                            |       | $                                  | (5,434     | ) | $ | (268 | ) |
| Adjustments to reconcile net income to net cash provided  by (used in) operating activities: |       |                               |       |   |   |
| Depreciation and amortization                                                                |       | 573                                |       | 573 |   |
| Amortization of deferred loan cost                                                           |       | 44                                 |       | 45 |   |
| Unit based compensation                                                                      |       | 72                                 |       | 77 |   |
| Loss (earnings) in Hiland Partners, LP                                                       |       | 2,252                              |       | (1,216 | ) |
| Increase in other assets                                                                     |       | —                             |       | (1 | ) |
| (Increase) decrease in current assets:                                                       |       |                               |       |   |   |
| Accounts receivable - affiliates                                                             |       | 2                                  |       | 3 |   |
| Other current assets                                                                         |       | 86                                 |       | (40 | ) |
| Increase (decrease) in current liabilities:                                                  |       |                               |       |   |   |
| Accounts payable - trade                                                                     |       | 971                                |       | 332 |   |
| Accounts payable - affiliates                                                                |       | 182                                |       | (254 | ) |
| **Net cash used in operating  activities**                                                   |       | (1,252                             | )          | (749 | ) |
| **Cash flows from investing  activities:**                                                   |       |                               |       |   |   |
| Investment in subsidiaries                                                                   |       | (1                                 | )          | (23 | ) |
| Cash distributions received from subsidiaries                                                |       | 2,513                              |       | 12,388 |   |
| **Net cash provided by investing  activities**                                               |       | 2,512                              |       | 12,365 |   |
| **Cash flows from financing  activities:**                                                   |       |                               |       |   |   |
| Proceeds from short-term borrowings                                                          |       | 500                                |       | — |   |
| Cash distributions to unitholders                                                            |       | (2,162                             | )          | (11,566 | ) |
| **Net cash used in financing  activities**                                                   |       | (1,662                             | )          | (11,566 | ) |
|                                                                                         |       |                               |       |   |   |
| Increase (decrease) for the period                                                           |       | (402                               | )          | 50 |   |
| Beginning of period                                                                          |       | 561                                |       | 105 |   |
| **End of period**                                                                            |       | $                                  | 159        |   | $ | 155 |   |
|                                                                                         |       |                               |       |   |   |
| Supplementary information                                                                    |       |                               |       |   |   |
| Cash paid for interest                                                                       |       | $                                  | 12         |   | $ | 20 |   |

 

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**Note16:   Subsequent Events**

 

On July 1, 2009, (i) the Partnership, Hiland Partners and itsgeneral partner, Hiland Partners GP, LLC, Hiland Partners GP Holdings, LLC, ourgeneral partner, HH GP Holding, LLC, an affiliate of Harold Hamm, HLNDMergerCo, LLC, a wholly-owned subsidiary of HH GP Holding, LLC, Harold Hamm,Chairman of the Hiland Companies, Joseph L. Griffin, Chief Executive Officerand President of the Hiland Companies, and Matthew S. Harrison, Chief FinancialOfficer, Vice President—Finance and Secretary of the Hiland Companies, inconnection with the Agreement and Plan of Merger, dated June 1, 2009,among Hiland Partners, Hiland Partners GP, LLC, HH GP Holding, LLC, and HLNDMergerCo, LLC filed a Transaction Statement on Schedule 13E-3 with the SEC and (ii) thePartnership, Hiland Partners GP Holdings, LLC, HH GP Holding, LLC, HPGP MergerCo, LLC, Continental Gas Holdings, Inc.(an affiliate of Mr. Hamm) and Messrs. Hamm, Griffin and Harrison, inconnection with the Agreement and Plan of Merger, dated June 1, 2009,among the Partnership, Hiland Partners GP Holdings, LLC, HH GP Holding, LLC andHPGP MergerCo, LLC, also filed a Transaction Statement on Schedule 13E-3 withthe SEC. Concurrently with the filing of these Schedule 13E-3s, thePartnership and Hiland Partners jointly filed a Preliminary Proxy Statement onSchedule 14A pursuant to the definitive version of which the boards ofdirectors of the general partner of each of the Partnership and Hiland Partnerswill be soliciting proxies from unitholders of the Partnership and HilandPartners in connection with the mergers of both Hiland Companies.

 

On July 10, 2009, the United States Federal Trade Commissiongranted early termination of the waiting period under the Hart-Scott-Rodino Actwith respect to the Hiland Partners Merger.

 

Pursuant to the terms of our existing credit agreement, we elected toreduce the commitment level on the credit facility from $10.0 million to $3.0million on August 7, 2009.  Concurrentlywith the reduction of the commitment level to $3.0 million, the existinglenders under the credit facility assigned their interests in the facility toThe Security National Bank of Enid and we entered into a first amended andrestated senior secured credit agreement with The Security National Bank ofEnid.  See Note 7 “Long-Term Debt.”

 

**CautionaryStatement About Forward-Looking Statements**

 

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

 

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

 

·      with respect to the mergers: (1) the occurrence of anyevent, change or other circumstances that could give rise to the termination ofthe merger agreements or the failure of required conditions to close themergers; (2) the outcome of any legal proceedings that have been or may beinstituted against Hiland Partners and/or the Partnership and others; (3) theinability to obtain unitholder approval or the failure to satisfy otherconditions to completion of the mergers, including the receipt of certain regulatoryapprovals; (4) risks that the proposed transaction disrupts current plansand operations and the potential difficulties in employee retention as a resultof the mergers; (5) the performance of Mr. Hamm, his affiliates andthe Hamm family trusts and (6) the amount of the costs, fees, expenses andrelated charges;

 

·      the ability to comply with the certain covenants in our orHiland Partners’ credit facilities and the ability to reach agreement with oursor Hiland Partners’ lenders in the event of a breach of such covenants;

 

·      the ability to pay distributions to our unitholders;

 

·      our expected receipt of distributions from Hiland Partners;

 

·      Hiland Partners’ cash flow is affected by the volatility ofnatural gas and NGL product prices, which could adversely affect HilandPartners ability to make distributions to its unitholders, including us;

 

·      Hiland Partners’ continued ability to find and contract for newsources of natural gas supply;

 

·      the general economic conditions in the United States of Americaas well as the general economic conditions and currencies in foreign countries;

 

·      the amount of natural gas gathered on Hiland Partners’gathering systems;

 

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·      the level of throughput in Hiland Partners’ natural gasprocessing and treating facilities given the recent reduction in drillingactivity in its areas of operations;

 

·      the fees Hiland Partners charges and the margins realized forits services;

 

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

 

·      energy prices generally;

 

·      the level of domestic crude oil and natural gas production;

 

·      the availability of imported crude oil and natural gas;

 

·      actions taken by foreign crude oil and natural gas producingnations;

 

·      the political and economic stability of petroleum producingnations;

 

·      the weather in Hiland Partners’ operating areas;

 

·      the extent of governmental regulation and taxation;

 

·      hazards or operating risks incidental to the gathering,treating and processing of natural gas and NGLs that may not be fully coveredby insurance;

 

·      competition from other midstream companies;

 

·      loss of key personnel;

 

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

 

·      changes in laws and regulations to which we and Hiland Partnersare subject, including tax, environmental, transportation and employmentregulations;

 

·      the costs and effects of legal and administrative proceedings;

 

·      the ability to successfully identify and consummate strategicacquisitions at purchase prices that are accretive to Hiland Partners’financial results;

 

·      risks associated with the construction of new pipelines andtreating and processing facilities or additions to Hiland Partners’ existingpipelines and facilities;

 

·      the completion of significant, unbudgeted expansion projectsmay require debt and/or equity financing which may not be available to HilandPartners on acceptable terms, or at all; and

 

·      increases in interest rates could increase Hiland Partners’borrowing costs, adversely impact its unit price and its ability to issueadditional equity, which could have an adverse effect on Hiland Partners’ cashflows and its ability to fund its growth.

 

These factors are not necessarily all of the important factors thatcould cause our actual results to differ materially from those expressed in anyof our forward-looking statements. Our future results will depend upon 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 circumstances afterthe date of the forward-looking statements.

 

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

 

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

 

**GeneralTrends and Outlook**

 

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

 

*U.S.Natural Gas Supply and Outlook.*    Natural gas prices have declinedsignificantly since the peak New York Mercantile Exchange (“NYMEX”) Henry Hublast day settle price of $13.11/MMBtu in July 2008 to the NYMEX Henry Hublast day settle price of $3.95 in July 2009, a 70% decline.  According to data published by Baker HughesIncorporated (“Baker Hughes”), U.S. natural gas drilling rig counts havedeclined by approximately 57% to 675 as of July 24, 2009, compared to1,555 natural gas drilling rigs as of July 25, 2008, and have declinedapproximately 58% compared to the peak natural gas drilling rig count of 1,606in September 2008.  We believe thatcurrent natural gas prices will continue to result in reduced naturalgas-related drilling activity as producers seek to decrease their level ofnatural gas production.  We also believethat current reduced natural gas drilling activity will persist until theeconomic environment in the United States improves and increases the demand fornatural gas.

 

*U.S. CrudeOil Supply and Outlook.*   The domestic and globalrecession and resulting drop in demand for crude oil products continues tosignificantly impact the price for crude oil. West Texas Intermediate (WTI)crude oil pricing has declined from a peak of $134.62/bbl in July 2008 toa low of $33.87/Bbl in January 2009, a 75% decline, increasing to$66.93/Bbl in July 2009, a 50% decline from July 2008.  According to data published by Baker Hughes,U.S. crude oil drilling rig counts have declined by approximately 35% to 257 asof July 24, 2009, compared to 393 crude oil drilling rigs as of July 25,2008, and have declined approximately 42% compared to the peak crude oildrilling rig count of 442 in November 2008.  Baker Hughes also published that U.S. crudeoil drilling rig counts have recently increased from a low of 179 as of June 5,2009 to 257 as of July 24, 2009, an increase of 44%.  Even though crude oil prices have steadilyincreased from $33.87/Bbl in January 2009 to $66.93/Bbl in July 2009,the forward curve for WTI crude oil pricing continues to reflect reductions indemand for crude oil. We also believe that current reduced crude oil drillingactivity will persist until the economic environment in the United Statesimproves and increases the demand for crude oil.

 

*U.S. NGLSupply and Outlook. *  The domestic and global recession andresulting drop in demand for NGL products has significantly impacted the pricefor NGLs.  NGL prices have droppeddramatically since the peak NGL basket pricing of $2.21/gallon in June 2008to a low of $0.70/gallon in January 2009, a 68% decline, increasing to$0.95/gallon in July 2009, a 57% decline from June 2008.  NGL basket pricing historically correlated toWTI crude oil pricing.  WTI crude oilpricing has declined from a peak of $134.62/bbl in July 2008 to a low of$33.87/Bbl in January 2009, a 75% decline, increasing to $66.93/Bbl in July 2009,a 50% decline from July 2008.  Theforward curve for NGL basket pricing and WTI crude oil pricing reflectscontinued reductions in demand for NGL products.  We also believe that the current reduced NGLproducts pricing will persist until the economic environment in the UnitedStates improves and increases the demand for NGL products.

 

A number of the areas in which Hiland Partners operates areexperiencing a significant decline in drilling activity as a result of therecent decline in natural gas and crude oil prices.  Along Hiland Partners’ systems, excluding itsNorth Dakota Bakken gathering system, which commenced operations in late April 2009,Hiland Partners connected 23 wells during the first six months of 2009 ascompared to 55 wells connected during the same period in 2008.  Currently, there is one rig drilling alongHiland Partners’ dedicated acreage company wide. While we anticipate continuedexploration and production activities in the areas in which Hiland Partnersoperates, albeit at depressed levels, fluctuations in energy prices can greatlyaffect production rates and investments by third parties in the development ofnatural gas and crude oil reserves. Drilling activity generally decreases as natural gas and crude oilprices decrease.  Hiland Partners has nocontrol over the level of drilling activity in the areas of its operations.

 

**Disruption to functioning ofcapital markets**

 

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

 

**Overview of Hiland Holdings**

 

We are a Delaware limited partnership formed in May 2006 to ownHiland Partners GP, LLC, the general partner of Hiland Partners, andcertain other common and subordinated units in Hiland Partners.  We reflect our ownership interest in HilandPartners on 

 

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a consolidatedbasis, which means that our financial results are combined with Hiland Partners’financial results. The noncontrolling partners’ interest in income (loss) ofHiland Partners is reflected as an equity amount of consolidated net income(loss) attributable to the noncontrolling partners’ interest on ourconsolidated statements of operations and the ownership interests of thenoncontrolling partners’ interest in Hiland Partners is presented within theequity section of our consolidated balance sheets. Hiland Partners GP, LLC’sresults of operations principally reflect the results of operations of HilandPartners and are adjusted for noncontrolling partners’ interests in HilandPartners’ net income (loss).

 

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

 

·         the2% general partner interest in Hiland Partners;

·         100%of the incentive distribution rights in Hiland Partners; and

·         2,321,471common units and 3,060,000 subordinated units of Hiland Partners, representinga 57.5% limited partner interest in Hiland Partners.

 

Hiland Partners is required by its partnership agreement to distributeall of its cash on hand at the end of each quarter, after establishing reservesto provide for the proper conduct of its business or to provide funds forfuture distributions. If commodity prices do not significantly improve abovethe current forward prices for 2009, Hiland Partners could be in violation ofthe maximum consolidated funded debt to EBITDA covenant ratio as early as September 30,2009, unless this ratio is amended, Hiland Partners receives an infusion ofequity capital, Hiland Partners’ debt is restructured or Hiland Partners isable to monetize “in-the-money” hedge positions.  Management is continuing extensive discussionswith certain lenders under the credit facility as to ways to address apotential covenant violation. While no potential solution has been agreed to,Hiland Partners expects that any solution will require the assessment of feesand increased rates, the infusion of additional equity capital or theincurrence of subordinated indebtedness by Hiland Partners and the suspensionof distributions for a certain period of time. There can be no assurance thatany such agreement will be reached with the lenders, that any required equityor debt financing will be available to Hiland Partners, or that Hiland Partners’hedge positions will be “in-the-money.

 

*Cash Distributions.  * Hiland Partners has suspended quarterlycash distributions on its common and subordinated units beginning with thefirst quarter distribution of 2009 due to the impact of lower commodity pricesand reduced drilling activity on Hiland Partners’ current and projectedthroughput volumes, midstream segment margins and cash flows combined withfuture required levels of capital expenditures and the outstanding indebtednessunder Hiland Partners’ senior secured revolving credit facility.  Under the terms of the Hiland Partnerspartnership agreement, the Hiland Partners common units carry an arrearage of$0.90 per unit, representing the minimum quarterly distribution to the HilandPartners common units for the first and second quarter of 2009 that must bepaid before Hiland Partners can make distributions to the Hiland Partnerssubordinated units.  We own 3,060,000 ofthe Hiland Partners subordinated units which will not receive a cashdistribution until the distribution arrearage to the Hiland Partners commonunits is paid. The following table presents Hiland Partners’ distributions paidto us on August 14, 2008 for the three and six months ended June 30,2008.

 

| ** **                                                   | ** ** | **Three Months**  | ** ** | **Six Months**    | ** ** |
|--------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                   | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                                   | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| **Hiland  Partner’s Distributions**                     | ** ** | **2008**          | ** ** | **2008**          | ** ** |
| Common units                                                 |       | $                 | 2,003      |              | $          | 3,080 |   |
| Subordinated units                                           |       | 2,639             |       | 6,015             |       |
| Ownership interest in Hiland Partners’ general  partner |       | 208               |       | 402               |       |
| General partners’ incentive distribution rights         |       | 2,107             |       | 3,896             |       |
|                                                         |       | $                 | 6,957      |              | $          | 13,393 |   |

 

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

 

**Overview of Hiland Partners**

 

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

 

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

 

·    *Midstream Segment,*which is engaged in purchasing, gathering, compressing, dehydrating, treating,processing and marketing of natural gas and the fractionating and marketing ofNGLs. The midstream segment generated 94.9% and 95.6% of total segment marginfor the three months ended June 30, 2009 and 2008, respectively and 94.6%and 95.2% of total segment margin for the six months ended June 30, 2009and 2008, respectively.

 

·    *Compression Segment,*which is engaged in providing air compression and water injection services foroil and gas secondary recovery operations that are ongoing in North Dakota. Thecompression segment generated 5.1% and 4.4% of total segment margin for thethree months ended June 30, 2009 and 2008, respectively and 5.4% and 4.8%of total segment margin for the six months ended June 30, 2009 and 2008,respectively.

 

Hiland Partners’ midstream assets currently consist of 15 natural gasgathering systems with approximately 2,147 miles of gas gatheringpipelines, six natural gas processing plants, seven natural gas treatingfacilities and three NGL fractionation facilities.  Hiland Partners’ compression assets consistof two air compression facilities and a water injection plant.

 

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

 

**Recent Events**

 

*Merger Agreements.*On June 1, 2009, the Partnership and HilandPartners signed separate definitive merger agreements with an affiliate ofHarold Hamm, pursuant to which affiliates of Mr. Hamm have agreed toacquire for cash (i) all of the outstanding common units of Hiland Partners (otherthan certain restricted common units owned by officers and employees) not ownedby the Partnership (the “Hiland Partners Merger”); and (ii) all of theoutstanding common units of the Partnership (other than certain restrictedcommon units owned by officers and employees) not owned by Mr. Hamm, hisaffiliates or the Hamm family trusts (the “Hiland Holdings Merger”).Upon consummation of the mergers, the common units of the Hiland Companies willno longer be publicly owned or publicly traded. In the mergers, the Partnership’s unitholders will receive $2.40 in cashfor each common unit they hold and Hiland Partners’ unitholders will receive$7.75 in cash for each common unit they hold. Conflicts committees comprised entirely of independent members of theboards of directors of the general partners of the Partnership and HilandPartners separately determined that the mergers are advisable, fair to and inthe best interests of the applicable Hiland Company and its public unitholders.In determining to make their recommendations to the boards of directors, eachconflicts committee considered, among other things, the fairness opinionreceived from its respective financial advisor. Based on the recommendation ofits conflicts committee, the board of directors of the general partner of eachof the Partnership and Hiland Partners has approved the applicable mergeragreement and has recommended, along with its respective conflicts committee,that the public unitholders of the Partnership and Hiland Partners,respectively, approve the applicable merger. Consummation of the HilandPartners Merger is subject to certain conditions, including the approval ofholders of a majority of our outstanding common units not owned by Mr. Hamm,his affiliates and the Hamm family trusts, the absence of any restraining orderor injunction, and other customary closing conditions.  Additionally, the obligation of Mr. Hammand his affiliates to complete the Hiland Holdings Merger is contingent uponthe concurrent completion of the Hiland Partners Merger, and the HilandPartners Merger is subject to closing conditions similar to those describedabove.  There can be no assurance thatthe Hiland Holdings Merger or any other transaction will be approved orconsummated.

 

On July 10, 2009, the United States Federal Trade Commissiongranted early termination of the waiting period under the Hart-Scott-Rodino Actwith respect to the Hiland Partners Merger.

 

*SEC Filings.*  On July 1,2009, (i) the Partnership, Hiland Partners and its general partner, HilandPartners GP, LLC, Hiland Partners GP Holdings, LLC, our general partner, HH GPHolding, LLC, an affiliate of Harold Hamm, HLND MergerCo, LLC, a wholly-ownedsubsidiary of HH GP Holding, LLC, Harold Hamm, Chairman of the HilandCompanies, Joseph L. Griffin, Chief Executive Officer and President of theHiland Companies, and Matthew S. Harrison, Chief Financial Officer, VicePresident—Finance and Secretary of the Hiland Companies, in connection with theAgreement and Plan of Merger, dated June 1, 2009, among Hiland Partners,Hiland Partners GP, LLC, HH GP Holding, LLC, and HLND MergerCo, LLC filed aTransaction Statement on Schedule 13E-3 with the SEC and (ii) the Partnership, HilandPartners GP Holdings, LLC, HH GP Holding, LLC, HPGP MergerCo, LLC, ContinentalGas Holdings, Inc. (an affiliate of Mr. Hamm) and Messrs. Hamm,Griffin and Harrison, in connection with the 

 

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Agreement and Plan of Merger, dated June 1,2009, among the Partnership, Hiland Partners GP Holdings, LLC, HH GP Holding,LLC and HPGP MergerCo, LLC, also filed a Transaction Statement on Schedule13E-3 with the SEC. Concurrentlywith the filing of these Schedule 13E-3s, the Partnership and HilandPartners jointly filed a Preliminary Proxy Statement on Schedule 14A pursuantto the definitive version of which the boards of directors of the generalpartner of each of the Partnership and Hiland Partners will be solicitingproxies from unitholders of the Partnership and Hiland Partners in connectionwith the mergers of both Hiland Companies.

 

*Hedging Transactions.* On June 26, 2009, Hiland Partners executed a series of hedgingtransactions that involved the unwinding of a portion of existing net “in-the-money”natural gas swaps and entered into a new 2010 Colorado Interstate Gas (“CIG”)natural gas swap. Hiland Partners received net proceeds of approximately $3.2million from the unwinding of the net “in-the-money” positions, of which $3.0million was used to reduce indebtedness under its senior secured revolvingcredit facility.

 

*Class Action Lawsuits*. Three putative unitholder class action lawsuits have been filed relatingto the Hiland Partners Merger and the Hiland Holdings Merger.  These lawsuits are as follows: (i) *Robert Pasternack v. Hiland Partners, LP et al.*, In theCourt of Chancery of the State of Delaware, Civil Action No. 4397-VCS; (ii) *Andrew Jones v. Hiland Partners, LP et al.*, In the Court ofChancery of the State of Delaware, Civil Action No. 4558-VCS; and (iii) *Arthur G. Rosenberg v. Hiland Partners, LP et al.*, In theDistrict Court of Garfield County, State of Oklahoma, Case No. C3-09-211-02.  The lawsuits name as defendants thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and the members of the board of directors of each of thePartnership and Hiland Partners.   Thelawsuits challenge both the Hiland Partners Merger and the Hiland Holdings Merger.  The lawsuits allege claims of breach of thePartnership Agreement and breach of fiduciary duty on behalf of (i) apurported class of common unitholders of the Partnership and (ii) apurported class of our common unitholders of Hiland Partners.

 

On July 10, 2009, the court in which the Oklahoma case is pendinggranted our motion to stay the Oklahoma lawsuit in favor of the Delawarelawsuits.   On July 31, 2009, theplaintiff in the first-filed Delaware case (*Pasternack*)filed an Amended Class Action Complaint and a motion to enjoin the mergers.   This Amended Class Action Complaintalleges, among other things, that (i) the original consideration andrevised consideration offered by the Hamm Parties is unfair and inadequate, (ii) themembers of the conflicts committees of the general partner of each of thePartnership and Hiland Partners that were charged with reviewing the proposalsand making a recommendation to each committee’s respective board of directorslacked any meaningful independence, (iii) the defendants acted in badfaith in recommending and approving the Hiland Partners Merger or the HilandHoldings Merger, and (iv) the disclosures in the Preliminary ProxyStatement filed by the Partnership and Hiland Partners are materiallymisleading.   The *Pasternack*plaintiffseeks to preliminarily enjoin the defendants from proceeding with orconsummating the mergers and seeks an order requiring defendants to supplementthe Preliminary Proxy Statement with certain information.  We cannot predict the outcome of theselawsuits, or others, nor can we predict the amount of time and expense thatwill be required to resolve the lawsuits.

 

Additional information concerning these lawsuits may be found in thePreliminary Proxy Statement filed by the Partnership and Hiland Partners and,when filed, in the definitive joint proxy statement.

 

*Distributions.* We and Hiland Partners have suspended quarterly cashdistributions on common and subordinated units beginning with the first quarterdistribution of 2009 due to the impact of lower commodity prices and reduceddrilling activity on Hiland Partners current and projected throughput volumes,midstream segment margins and cash flows combined with future required levelsof capital expenditures and the outstanding indebtedness under ours and HilandPartners’ senior secured revolving credit facilities.  Under the terms of Hiland Partners’partnership agreement, Hiland Partners’ common units will carry an arrearage of$0.90 per unit, representing the minimum quarterly distribution to its commonunits for the first and second quarters of 2009 that must be paid before HilandPartners’ can make distributions to the subordinated units.

 

*CreditFacility*.  Pursuant to the terms of our existing creditagreement, we elected to reduce the commitment level on the credit facilityfrom $10.0 million to $3.0 million on August 7, 2009.  Concurrently with the reduction of thecommitment level to $3.0 million, the existing lenders under the creditfacility assigned their interests in the facility to The Security National Bankof Enid and we entered into a first amended and restated senior secured creditagreement with The Security National Bank of Enid.   The credit facility is secured by all of ourownership interests in Hiland Partners and its general partner, other than the2% general partner interest and the incentive distribution rights. The creditfacility will mature on December 31, 2009, at which time all outstandingamounts thereunder become due and payable.

 

**Historical Results of Operations**

 

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

 

**Our Results of Operations**

 

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

 

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Hiland Partnersfrom third parties, the cost of natural gas, condensate and NGLs purchased byHiland Partners from affiliates, and the cost of crude oil purchased by HilandPartners from third parties. We define compression segment margin as therevenue derived from Hiland Partners’ compression segment. Total segment marginmay not be comparable to similarly titled measures of other companies as othercompanies may not calculate total segment margin in the same manner.

 

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

 

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

 

| ** **                                                               | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                             | ** ** | **2008** | ** ** |
| ** **                                                               | ** ** | **(in thousands)**                   | ** ** |
| **Total  Segment Margin Data:**                                          | ** ** | ** **                           |       |   |   |
| Midstream revenues                                                       |       | $                                    | 48,874     |   | $ | 114,236 |   |
| Midstream purchases                                                      |       | 26,999                               |       | 88,073 |   |
| Midstream segment margin                                                 |       | 21,875                               |       | 26,163 |   |
| Compression revenues (1)                                                 |       | 1,205                                |       | 1,205 |   |
| Total segment margin (2)                                                 |       | $                                    | 23,080     |   | $ | 27,368 |   |
|                                                                     |       |                                 |       |   |   |
| **Summary of  Operations Data:**                                         | ** ** | ** **                           | ** ** |   | ** ** |
| Midstream revenues                                                       |       | $                                    | 48,874     |   | $ | 114,236 |   |
| Compression revenues                                                     |       | 1,205                                |       | 1,205 |   |
| Total revenues                                                           |       | 50,079                               |       | 115,441 |   |
|                                                                     |       |                                 |       |   |   |
| Midstream purchases  (exclusive of items shown separately below)         |       | 26,999                               |       | 88,073 |   |
| Operations and maintenance                                               |       | 7,785                                |       | 7,551 |   |
| Depreciation, amortization  and accretion                                |       | 10,824                               |       | 9,456 |   |
| Bad debt                                                                 |       | —                               |       | 8,103 |   |
| General and administrative                                               |       | 4,606                                |       | 2,333 |   |
| Total operating costs and  expenses                                      |       | 50,214                               |       | 115,516 |   |
| Operating loss                                                           |       | (135                                 | )          | (75 | ) |
| Other income (expense), net                                              |       | (2,795                               | )          | (3,225 | ) |
| Net loss                                                                 |       | (2,930                               | )          | (3,300 | ) |
| Less: Noncontrolling  partners’ interest in loss of Hiland Partners |       | (395                                 | )          | (2,192 | ) |
| **Limited  partners’ interest in net loss**                         |       | $                                    | (2,535     | ) | $ | (1,108 | ) |
|                                                                     |       |                                 |       |   |   |
| **Hiland  Partners Operating Data:**                                     |       |                                 |       |   |   |
| Inlet natural gas (Mcf/d)                                                |       | 272,666                              |       | 246,339 |   |
| Natural gas sales (MMBtu/d)                                              |       | 87,273                               |       | 86,203 |   |
| NGL sales (Bbls/d)                                                       |       | 7,260                                |       | 5,979 |   |

 

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| ** **                                                               | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                               | ** ** | **2009**                           | ** ** | **2008** | ** ** |
| ** **                                                               | ** ** | **(in thousands)**                 | ** ** |
| **Total  Segment Margin Data:**                                          | ** ** | ** **                         |       |   |   |
| Midstream revenues                                                       |       | $                                  | 100,017    |   | $ | 204,510 |   |
| Midstream purchases                                                      |       | 58,215                             |       | 156,691 |   |
| Midstream segment margin                                                 |       | 41,802                             |       | 47,819 |   |
| Compression revenues (1)                                                 |       | 2,410                              |       | 2,410 |   |
| Total segment margin (2)                                                 |       | $                                  | 44,212     |   | $ | 50,229 |   |
|                                                                     |       |                               |       |   |   |
| **Summary of  Operations Data:**                                         | ** ** | ** **                         | ** ** |   | ** ** |
| Midstream revenues                                                       |       | $                                  | 100,017    |   | $ | 204,510 |   |
| Compression revenues                                                     |       | 2,410                              |       | 2,410 |   |
| Total revenues                                                           |       | 102,427                            |       | 206,920 |   |
|                                                                     |       |                               |       |   |   |
| Midstream purchases  (exclusive of items shown separately below)         |       | 58,215                             |       | 156,691 |   |
| Operations and maintenance                                               |       | 15,480                             |       | 14,320 |   |
| Depreciation, amortization  and accretion                                |       | 21,082                             |       | 18,671 |   |
| Property impairments                                                     |       | 950                                |       | — |   |
| Bad debt                                                                 |       | —                             |       | 8,103 |   |
| General and administrative                                               |       | 8,433                              |       | 5,018 |   |
| Total operating costs and  expenses                                      |       | 104,160                            |       | 202,803 |   |
| Operating loss                                                           |       | (1,733                             | )          | 4,117 |   |
| Other income (expense), net                                              |       | (5,311                             | )          | (6,783 | ) |
| Net loss                                                                 |       | (7,044                             | )          | (2,666 | ) |
| Less: Noncontrolling  partners’ interest in loss of Hiland Partners |       | (1,610                             | )          | (2,398 | ) |
| **Limited  partners’ interest in net loss**                         |       | $                                  | (5,434     | ) | $ | (268 | ) |
|                                                                     |       |                               |       |   |   |
| **Hiland  Partners Operating Data:**                                     |       |                               |       |   |   |
| Inlet natural gas (MCF/d)                                                |       | 274,521                            |       | 236,885 |   |
| Natural gas sales (MMBTU/d)                                              |       | 89,579                             |       | 86,174 |   |
| NGL sales (Bbls/d)                                                       |       | 7,155                              |       | 5,626 |   |

 

----

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

 

(2) Reconciliationof total segment margin to operating income:

 

| ** **                                                    | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                    | ** ** | **2009**                             | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                   | ** ** |
| **Reconciliation  of Total Segment Margin to Operating Loss** |       |                                 |       |   |   |
| Operating loss                                                |       | $                                    | (135       | ) | $ | (75 | ) |
| Add:                                                          |       |                                 |       |   |   |
| Operations and maintenance  expenses                          |       | 7,785                                |       | 7,551 |   |
| Depreciation, amortization  and accretion                     |       | 10,824                               |       | 9,456 |   |
| Bad debt                                                      |       | —                               |       | 8,103 |   |
| General and administrative                                    |       | 4,606                                |       | 2,333 |   |
| Total segment margin                                          |       | $                                    | 23,080     |   | $ | 27,368 |   |

 

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| ** **                                                             | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                             | ** ** | **2009**                           | ** ** | **2008** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**                 | ** ** |
| **Reconciliation  of Total Segment Margin to Operating (loss) Income** |       |                               |       |   |   |
| Operating (loss) income                                                |       | $                                  | (1,733     | ) | $ | 4,117 |   |
| Add:                                                                   |       |                               |       |   |   |
| Operations and maintenance  expenses                                   |       | 15,480                             |       | 14,320 |   |
| Depreciation, amortization  and accretion                              |       | 21,082                             |       | 18,671 |   |
| Property impairments                                                   |       | 950                                |       | — |   |
| Bad debt                                                               |       | —                             |       | 8,103 |   |
| General and administrative                                             |       | 8,433                              |       | 5,018 |   |
| Total segment margin                                                   |       | $                                  | 44,212     |   | $ | 50,229 |   |

 

**Three Months Ended June 30, 2009 Comparedwith Three Months Ended June 30, 2008**

 

***Revenues.***  Total revenues (midstream andcompression) were $50.1 million for the three months ended June 30, 2009compared to $115.4 million for the three months ended June 30, 2008, adecrease of $65.4 million, or (56.7%).  This $65.4 million decrease wasprimarily due to significantly lower average realized natural gas and NGL salesprices for all of our gathering systems. Natural gas sales volumes increased by7,297 MMBtu/d (MMBtu per day) at the Woodford Shale and Kinta Area gatheringsystems and NGL sales volumes increased by 1,299 Bbls/d (Bbls per day) at theWoodford Shale, Badlands and Matli gathering systems for the three months endedJune 30, 2009 compared to the same period in 2008.  The North Dakota Bakken gathering system,which commenced operations in late April 2009, contributed natural gassales volumes of 1,323 MMBtu/d and NGL sales volumes of 919 Bbls/d during thethree months ended June 30, 2009. Natural gas sales volumes decreased by7,225 MMBtu/d at the Eagle Chief, Matli and Badlands gathering systems and NGLsales volumes decreased by 223 Bbls/d at the Bakken and Eagle Chief gatheringsystems compared to the same period in 2008.  Revenues from compressionassets were the same for both periods.

 

Midstream revenues were $48.9 million for the three months ended June 30,2009 compared to $114.2 million for the three months ended June 30, 2008,a decrease of $65.4 million, or (57.2%). Of this $65.4 million decrease in midstream revenues, approximately$73.9 million was attributable to significantly lower average realized naturalgas and NGL sales prices for all of our gathering systems, partially offset byapproximately $8.5 million attributable to revenues from overall increases innatural gas and NGL sales volumes for the three months ended June 30, 2009as compared to the same period in 2008.

 

Inlet natural gas was 272,666 Mcf/d (Mcf per day) for the three monthsended June 30, 2009 compared to 246,339 Mcf/d for the three months ended June 30,2008, an increase of 26,327 Mcf/d, or 10.7%. This increase is primarily attributable to volume growth totaling 31,111Mcf/d at the Kinta Area, Woodford Shale and Badlands gathering systems and volumesof 2,171 Mcf/d at the North Dakota Bakken gathering system, which commencedoperations in late April 2009, offset by volume declines totaling 6,616Mcf/d at the Eagle Chief and Matli gathering systems.

 

Natural gas sales volumes were 87,273 MMBtu/d for the three monthsended June 30, 2009 compared to 86,203 MMBtu/d for the three months ended June 30,2008, an increase of 1,070 MMBtu/d, or 1.2%.  This 1,070 MMBtu/d netincrease in natural gas sales volumes was attributable to increased natural gassales volumes of 7,297 MMBtu/d at the Woodford Shale and Kinta Area gatheringsystems and natural gas sales volumes of 1,323 MMBtu/d at the North DakotaBakken gathering system which commenced operations in late April 2009,offset by reduced natural gas sales volumes totaling 7,225 MMBtu/d at our EagleChief, Matli and Badlands gathering systems.

 

NGL sales volumes were 7,260 Bbls/d for the three months ended June 30,2009 compared to 5,979 Bbls/d for the three months ended June 30, 2008, anet increase of 1,281 Bbls/d, or 21.4%.  This 1,281 Bbls/d net increase inNGL sales volumes is primarily attributable to increased NGL sales volumestotaling 1,299 Bbls/d at the Woodford Shale, Badlands and Matli gatheringsystems and NGL sales volumes of 206 Bbls/d at the North Dakota Bakkengathering system, which commenced operations in late April 2009, offset byreduced NGL sales volumes totaling 223 Bbls/d at our Bakken and Eagle Chiefgathering systems.

 

Average realized natural gas sales prices were $3.02 per MMBtu for thethree months ended June 30, 2009 compared to $9.29 per MMBtu for the threemonths ended June 30, 2008, a decrease of $6.27 per MMBtu, or(67.5%).  Average realized NGL sales prices were $0.66 per gallon for thethree months ended June 30, 2009 compared to $1.64 per gallon for thethree months ended June 30, 2008, a decrease of $0.98 per gallon or(59.8%).  The decrease in our average realized natural gas and NGL salesprices was primarily a result of significantly lower index prices for naturalgas and posted prices for NGLs during the three months ended June 30, 2009compared to the three months ended June 30, 2008.

 

Net cash received from our counterparty on cash flow swap contracts fornatural gas sales and natural gas purchase derivative transactions that closedduring the three months ended June 30, 2009 totaled $2.6 million comparedto $0.1 million for the three months ended June 30, 2008.  The $2.6million gain for the three months ended June 30, 2009 increased averagedrealized natural gas prices to $3.02 per MMBtu from $2.69 per MMBtu, anincrease of $0.33 per MMBtu.  The $0.1million net gain was immaterial to 

 

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average realizednatural gas sales prices for the three months ended June 30, 2008. We had no cash flow swap contracts for NGLs during the three months ended June 30,2009.  Cash paid to our counterparty oncash flow swap contracts for NGL derivative transactions that closed during thethree months ended June 30, 2008 totaled $3.1 million.  The $3.1million loss for the three months ended June 30, 2008 reduced averagedrealized NGL prices to $1.64 per gallon from $1.76 per gallon, a decrease of $0.12per gallon.

 

Compression revenues were $1.2 million for the each of the three monthsended June 30, 2009 and 2008.

 

***MidstreamPurchases.*** Midstream purchases were $27.0 million for the three months ended June 30,2009 compared to $88.1 million for the three months ended June 30, 2008, adecrease of $61.1 million, or (69.3%).  This $61.1 million decrease is dueto significantly reduced natural gas and NGL purchase prices, resulting indecreased midstream purchases for all of our gathering systems compared to thesame period in 2008, with the exception of $0.6 million of midstream purchasesat the North Dakota Bakken gathering system, which commenced operations in lateApril 2009.

 

***Midstream SegmentMargin.*** Midstream segment margin was $21.9 million for the three months ended June 30,2009 compared to $26.2 million for the three months ended June 30, 2008, adecrease of $4.3 million, or (16.4%). The decrease is primarily due to unfavorable gross processing spreadsand significantly lower average realized natural gas and NGL prices despite theoverall increase in volumes.  As apercent of midstream revenues, midstream segment margin was 44.8% for the threemonths ended June 30, 2009 compared to 22.9% for the three months ended June 30,2008, an increase of 21.9%.  Thisincrease is attributable to (i) the positive impact of fixed feearrangement contracts which are not affected by realized natural gas and NGLselling prices, (ii) improvements in third party processing arrangementsat the Woodford Shale gathering system, (iii) increased volumes underfavorable percentage-of-proceeds contracts at the North Dakota Bakken andBadlands gathering systems and (iv) gains on closed/settled derivativetransactions and unrealized non-cash gains on open derivative transactions forthe three months ended June 30, 2009 totaling $2.8 million compared to netlosses of $3.1 million on closed/settled derivative transactions and unrealizednon-cash losses on open derivative transactions for the three months ended June 30,2008, including an unrealized non-cash loss of $1.5 million related to anon-qualifying mark-to-market cash flow hedge for forecasted sales in 2010.

 

***Operations andMaintenance.*** Operations and maintenance expense totaled $7.8 million for the three monthsended June 30, 2009 compared with $7.6 million for the three months ended June 30,2008, a net increase of only $0.2 million, or 3.1%.  The net increase in operations andmaintenance of $0.2 million compared to the same period in 2008 includes (i) anincrease of $0.2 million at the Badlands gathering system, (ii) $0.4million attributable to the North Dakota Bakken gathering system, whichcommenced operations in late April 2009, (iii) decreases totaling$0.4 million at the Kinta Area, Worland, Eagle Chief and Matli gatheringsystems and (iv) a decrease of $0.1 million related to compressionoperations.

 

***Depreciation, Amortization and Accretion.***  Depreciation, amortization andaccretion expense totaled $10.8 million for the three months ended June 30,2009 compared with $9.5 million for the three months ended June 30, 2008,an increase of $1.4 million, or 14.5 %.  This $1.4 million increase wasprimarily attributable to increased depreciation of $0.5 million on the KintaArea gathering system, $0.3 million each on the Woodford Shale and Badlandsgathering systems and $0.2 million attributable to the North Dakota Bakkengathering system, which commenced operations in late April 2009.

 

***Bad Debt.***  Neither we nor Hiland Partners hada bad debt for the three months ended June 30, 2009. For the three monthsended June 30, 2008, Hiland Partners determined that collection of a tradeaccounts receivable from a significant customer totaling $8.1 million wasdoubtful. Accordingly, Hiland Partners increased its reserve for doubtfulaccounts and recorded a bad debt expense of $8.1 million.

 

***General and Administrative.***  General and administrative expense totaled $4.6million for the three months ended June 30, 2009 compared with $2.3million for the three months ended June 30, 2008, an increase of $2.3million, or 97.4%. Expenses related to the going private proposals were $2.4million for the three months ended June 30, 2009.  Public company expenses and directors feesdecreased by $0.1 million for the three months ended June 30, 2009 ascompared to the three months ended June 30, 2008.

 

***Other Income (Expense).*** Other income (expense) totaled $(2.8) millionfor the three months ended June 30, 2009 compared with $(3.2) million forthe three months ended June 30, 2008, a decrease in expense of $0.4million.  The decrease is primarily attributable lower interest ratesincurred on Hiland Partners’ credit facilty during the three months ended June 30,2009 compared to interest rates incurred during the three months ended June 30,2008, offset by interest expense of $0.5 million related to Hiland Partners’interest rate swap during the three months ended June 30, 2009 which didnot exist in 2008 and increased interest expense on our and Hiland Partners’additional borrowings for the three months ended June 30, 2009 compared tothe same period in 2008.

 

***Noncontrolling Partners’ Interest in Loss of HilandPartners.  *** The noncontrolling partners’ interest in loss of Hiland Partners,which represents the allocation of Hiland Partners earnings or loss to itslimited partner interests not owned by us, totaled a loss of $0.4 million forthe three months ended June 30, 2009 compared to a $2.2 million loss forthe three months ended June 30, 2008, a decreased loss of $1.8 million.

 

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**Six Months Ended June 30, 2009 Compared withSix Months Ended June 30, 2008**

 

***Revenues.***  Total revenues (midstream andcompression) were $102.4 million for the six months ended June 30, 2009compared to $206.9 million for the six months ended June 30, 2008, adecrease of $104.5 million, or (51.0%).  This $104.5 million decrease wasprimarily due to significantly lower average realized natural gas and NGL salesprices for all of our gathering systems. Natural gas sales volumes increased by7,838 MMBtu/d at the Woodford Shale, Kinta Area, Badlands and Bakken gatheringsystems and NGL sales volumes increased by 1,637 Bbls/d at the Woodford Shale,Badlands and Matli gathering systems for the six months ended June 30,2009 compared to the same period in 2008. The North Dakota Bakken gathering system, which commenced operations inlate April 2009, contributed natural gas sales volumes of 1,323 MMBtu/dand NGL sales volumes of 919 Bbls/d during the six months ended June 30,2009. Natural gas sales volumes decreased by 4,700 MMBtu/d at the Eagle Chiefand Matli gathering systems and NGL sales volumes decreased by 200 Bbls/d atthe Eagle Chief and Bakken gathering systems compared to the same period in2008.  Revenues from compression assets were the same for both periods.

 

Midstream revenues were $100.0 million for the six months ended June 30,2009 compared to $204.5 million for the six months ended June 30, 2008, adecrease of $104.5 million, or (51.1%). Of this $104.5 million decrease in midstream revenues, approximately$126.9 million was attributable to significantly lower average realized naturalgas and NGL sales prices for all of our gathering systems, partially offset byapproximately $22.4 million attributable to revenues from overall increases innatural gas and NGL sales volumes for the six months ended June 30, 2009as compared to the same period in 2008.

 

Inlet natural gas was 274,521 Mcf/d (Mcf per day) for the six monthsended June 30, 2009 compared to 236,885 Mcf/d for the six months ended June 30,2008, an increase of 37,636 Mcf/d, or 15.9%. This increase is primarily attributable to volume growth totaling 42,260Mcf/d at the Woodford Shale, Kinta Area and Badlands gathering systems, volumesof 1,091 Mcf/d at the North Dakota Bakken gathering system, which commencedoperations in late April 2009, offset by volume declines totaling 5,316Mcf/d at the Eagle Chief and Matli gathering systems.

 

Natural gas sales volumes were 89,579 MMBtu/d for the six months ended June 30,2009 compared to 86,174 MMBtu/d for the six months ended June 30, 2008, anincrease of 3,405 MMBtu/d, or 4.0%.  This 3,405 MMBtu/d net increase innatural gas sales volumes was attributable to increased natural gas salesvolumes of 7,640 MMBtu/d at the Woodford Shale and Kinta Area gatheringsystems, natural gas sales volumes of 665 MMBtu/d at the North Dakota Bakkengathering system, which commenced operations in late April 2009, offset byreduced natural gas sales volumes totaling 4,700 MMBtu/d at our Eagle Chief andMatli gathering systems.

 

NGL sales volumes were 7,155 Bbls/d for the six months ended June 30,2009 compared to 5,626 Bbls/d for the six months ended June 30, 2008, anet increase of 1,529 Bbls/d, or 27.2%.  This 1,529 Bbls/d net increase inNGL sales volumes is primarily attributable to increased NGL sales volumestotaling 1,637 Bbls/d at our Woodford Shale, Badlands and Matli gatheringsystems, NGL sales volumes of 104 Bbls/d at the North Dakota Bakken gatheringsystem, which commenced operations in late April 2009, offset by reducedNGL sales volumes totaling 200 Bbls/d at our Eagle Chief and Bakken gatheringsystems.

 

Average realized natural gas sales prices were $3.36 per MMBtu for thesix months ended June 30, 2009 compared to $8.29 per MMBtu for the sixmonths ended June 30, 2008, a decrease of $4.93 per MMBtu, or(59.5%).  Average realized NGL sales prices were $0.62 per gallon for thesix months ended June 30, 2009 compared to $1.53 per gallon for the sixmonths ended June 30, 2008, a decrease of $0.91 per gallon or(59.5%).  The decrease in our average realized natural gas and NGL salesprices was primarily a result of significantly lower index prices for naturalgas and posted prices for NGLs during the six months ended June 30, 2009compared to the six months ended June 30, 2008.

 

Net cash received from our counterparty on cash flow swap contracts fornatural gas sales and natural gas purchase derivative transactions that closedduring the six months ended June 30, 2009 totaled $4.8 million compared to$0.2 million for the six months ended June 30, 2008.  The $4.8million gain for the six months ended June 30, 2009 increased averagedrealized natural gas prices to $3.36 per MMBtu from $3.06 per MMBtu, anincrease of $0.3 per MMBtu.  The $0.2million net gain for the six months ended June 30, 2008 increased averagedrealized natural gas prices to $8.29 per MMBtu from $8.28 per MMBtu, anincrease of $0.01 per MMBtu.  We had no cash flow swap contracts for NGLsduring the six months ended June 30, 2009. Cash paid to our counterparty on cash flow swap contracts for NGLderivative transactions that closed during the six months ended June 30,2008 totaled $5.3 million.  The $5.3 million loss for the six monthsended June 30, 2008 reduced averaged realized NGL prices to $1.53 pergallon from $1.64 per MMBtu, a decrease of $0.11 per gallon.

 

Compression revenues were $2.4 million for the each of the six monthsended June 30, 2009 and 2008.

 

***MidstreamPurchases.*** Midstream purchases were $58.2 million for the six months ended June 30,2009 compared to $156.7 million for the six months ended June 30, 2008, adecrease of $98.5 million, or (62.9%).  This $98.5 million decrease is dueto significantly reduced natural gas and NGL purchase prices, resulting indecreased midstream purchases for all of the gathering

 

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systems comparedto the same period in 2008, with the exception of $0.6 million of midstreampurchases at the North Dakota Bakken gathering system, which commencedoperations in late April 2009.

 

***Midstream SegmentMargin.*** Midstream segment margin was $41.8 million for the six months ended June 30,2009 compared to $47.8 million for the six months ended June 30, 2008, adecrease of $6.0 million, or (12.6%). The decrease is primarily due to unfavorable gross processing spreadsand significantly lower average realized natural gas and NGL prices despite theoverall increase in volumes and approximately $2.3 million of foregone marginas a result of the nitrogen rejection plant at the Badlands gathering systembeing taken out of service due to equipment failure during the three monthsended March 31, 2008.  As a percentof midstream revenues, midstream segment margin was 42.2% for the six monthsended June 30, 2009 compared to 23.4% for the six months ended June 30,2008, an increase of 18.8%.  Thisincrease is attributable to (i) the positive impact of fixed feearrangement contracts which are not affected by realized natural gas and NGLselling prices, (ii) improvements in third party processing arrangementsat the Woodford Shale gathering system, (iii) increased volumes underfavorable percentage-of-proceeds contracts at the North Dakota Bakken andBadlands gathering systems and (iv) gains on closed/settled derivativetransactions and unrealized non-cash gains on open derivative transactions forthe six months ended June 30, 2009 totaling $4.9 million compared to netlosses of $5.5 million on closed/settled derivative transactions and unrealizednon-cash losses on open derivative transactions for the six months ended June 30,2008, including an unrealized non-cash loss of $1.5 million related to anon-qualifying mark-to-market cash flow hedge for forecasted sales in 2010.

 

***Operations andMaintenance.*** Operations and maintenance expense totaled $15.5 million for the six monthsended June 30, 2009 compared with $14.3 million for the six months ended June 30,2008, an increase of $1.2 million, or 8.1%. The net increase in operations and maintenance of $1.2 million comparedto the same period in 2008 includes (i) increases of $0.9 million and $0.1million at the Badlands and Woodford Shale gathering systems, respectively,(ii) $0.5 million attributable to the North Dakota Bakken gathering system,which commenced operations in late April 2009, (iii) decreasestotaling $0.3 million at the Worland, Kinta Area, Bakken, Eagle Chief and Matligathering systems and (iv) a decrease of $0.1 million related tocompression operations.

 

***Depreciation,Amortization and Accretion.***  Depreciation, amortization and accretionexpense totaled $21.1 million for the six months ended June 30, 2009compared with $18.7 million for the six months ended June 30, 2008, anincrease of $2.4 million, or 12.9 %.  This $2.4 million increase wasprimarily attributable to increased depreciation of $0.8 million on theWoodford Shale gathering system $0.7 million on the Kinta Area gatheringsystem, $0.5 million on the Badlands gathering system and $0.2 millionattributable to the North Dakota Bakken gathering system, which commencedoperations in late April 2009.

 

***PropertyImpairments.*** Property impairment expense related to natural gas gathering systems in Texasand Mississippi totaled $1.0 million for the six months ended June 30,2009. Hiland Partners had no property impairments during the six months ended June 30,2008.

 

***Bad Debt.***  Neither we nor Hiland Partners hada bad debt for the six months ended June 30, 2009.  For the six months ended June 30, 2008Hiland Partners determined that collection of a trade accounts receivable froma significant customer totaling $8.1 million was doubtful. Accordingly, HilandPartners increased its reserve for doubtful accounts and recorded a bad debtexpense of $8.1 million.

 

***General andAdministrative.*** General and administrative expense totaled $8.4 million for the six monthsended June 30, 2009 compared with $5.0 million for the six months ended June 30,2008, an increase of $3.4 million, or 68.1%. Expenses related to the going private proposals were $3.2 million forthe six months ended June 30, 2009. Salaries expense increased by $0.3 million as a result of increasedstaffing and public company expenses decreased by $0.1 million during the sixmonths ended June 30, 2009 as compared to the six months ended June 30,2008.

 

***Other Income(Expense).*** Otherincome (expense) totaled $(5.3) million for the six months ended June 30,2009 compared with $(6.8) million for the six months ended June 30, 2008,a decrease in expense of $1.5 million.  The decrease is primarilyattributable lower interest rates incurred on Hiland Partners’ credit faciltyduring the six months ended June 30, 2009 compared to interest ratesincurred during the six months ended June 30, 2008, offset by interestexpense of $0.9 million related to Hiland Partners’ interest rate swap duringthe six months ended June 30, 2009 which did not exist in 2008 andincreased interest expense on our and Hiland Partners’ additional borrowingsfor the six months ended June 30, 2009 compared to the same period in2008.

 

***Noncontrolling Partners’ Interest in Loss of Hiland Partners.  *** The noncontrolling partners’ interest in loss ofHiland Partners, which represents the allocation of Hiland Partners earnings orloss to its limited partner interests not owned by us, totaled a loss of $1.6million for the six months ended June 30, 2009 compared to a $2.4 millionloss for the six months ended June 30, 2008, a decreased loss of $0.8million.

 

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** **

**LIQUIDITY AND CAPITAL RESOURCES**

 

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

 

The drop in demand for natural gas, crude oil and NGL products sincethe third quarter of 2008 continues to impact the price for natural gas, crudeoil and NGLs. Natural gas prices have declined significantly since the peakNYMEX Henry Hub last day settle price of $13.11/MMBtu in July 2008 to theNYMEX Henry Hub last day settle price of $3.95 in July 2009, a 70%decline.  WTI crude oil pricing hasdeclined from a peak of $134.62/bbl in July 2008 to a low of $33.87/Bbl inJanuary 2009, a 75% decline, increasing to $66.93/Bbl in July 2009, a50% decline from July 2008.  NGLbasket pricing, which historically has correlated to WTI crude oil pricing, hasdropped since the peak NGL basket pricing of $2.21/gallon in June 2008 toa low of $0.70/gallon in January 2009, a 68% decline, increasing to$0.95/gallon in July 2009, a 57% decline from June 2008.  Forward curves for natural gas, crude oil andNGL basket pricing reflect continued reductions in demand for natural gas,crude oil and NGL products.  A number ofthe areas in which Hiland Partners operates are experiencing a significantdecline in drilling activity as a result of the recent decline in natural gasand crude oil prices.  While HilandPartners anticipates continued exploration and production activities in theareas in which it operates, albeit at depressed levels, fluctuations in energyprices can greatly affect production rates and investments by third parties inthe development of natural gas and crude oil reserves.  Drilling activity generally decreases asnatural gas and crude oil prices decrease. Hiland Partners has no control over the level of drilling activity inthe areas of its operations.

 

***Disruption toFunctioning of Capital Markets***

 

Multiple events during 2008 and 2009 involving numerous financialinstitutions have effectively restricted current liquidity within the capitalmarkets throughout the United States and around the world. Despite efforts bytreasury and banking regulators in the United States, Europe and other nationsaround the world to provide liquidity to the financial sector, capital marketscurrently remain constrained. We expect that our ability to issue debt andequity at prices that are similar to offerings in recent years will be limitedover the next three to six months and possibly longer should capital marketsremain constrained. Although Hiland Partners intends to move forward with itsplanned capital expenditures attributable to its existing facilities,  Hiland Partners  may revise the timing and scope of theseprojects as necessary to adapt to existing economic conditions and the benefitsexpected to accrue to our and Hiland Partners’ unitholders from Hiland Partners’capital expenditures may be muted by substantial cost of capital increasesduring this period.

 

***Overview***

 

Due to lower natural gas and NGL prices and the impact of reduceddrilling activity on Hiland Partners’ current and projected throughput volumes,Hiland Partners believes that cash generated from operations will decrease forthe remainder of 2009 relative to comparable periods in 2008.  Hiland Partners’ senior secured revolvingcredit facility requires Hiland Partners to meet certain financial tests,including a maximum consolidated funded debt to EBITDA covenant ratio of4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscal quartersfollowing the quarter in which such permitted acquisition or capitalexpenditure occurs.  Hiland Partners metthe permitted capital expenditure requirements for the four quarter periodended March 31, 2009 and elected to increase the ratio to 4.75:1.0 on March 31,2009 for the quarters ended March 31, 2009, June 30, 2009 and September 30,2009.  During this step-up period, theapplicable margin with respect to loans under the credit facility increases by35 basis points per annum and the unused commitment fee increases by 12.5 basispoints per annum. The ratio will revert back to 4.0:1.0 for the quarter ended December 31,2009.  If commodity prices do notsignificantly improve above the current forward prices for 2009, HilandPartners could be in violation of the maximum consolidated funded debt toEBITDA covenant ratio as early as September 30, 2009, unless this ratio isamended, Hiland Partners receives an infusion of equity capital, HilandPartners’ debt is restructured or Hiland Partners is able to monetize “in-the-money”hedge positions.  Management iscontinuing extensive discussions with certain lenders under the credit facilityas to ways to address a potential covenant violation. While no potentialsolution has been agreed to, Hiland Partners expects that any solution willrequire the assessment of fees and increased rates, the infusion of additionalequity capital or the incurrence of subordinated indebtedness by HilandPartners and the suspension of distributions for a certain period of time. Therecan be no assurance that any such agreement will be reached with the lenders,that any required equity or debt financing will be available to HilandPartners, or that Hiland Partners’ hedge positions will be “in-the-money.”

 

We rely on distributions from Hiland Partners to fund cash requirementsfor our operations. Cash generated from operations, borrowings under HilandPartners’ credit facility and funds from private or public equity and futuredebt offerings have historically been Hiland Partners’ primary sources ofliquidity. We believe that funds from these sources should be sufficient tomeet both Hiland Partners’ short-term working capital requirements and itslong-term capital expenditure requirements. Hiland Partners’ ability to paydistributions to unitholders, to fund planned capital expenditures and to makeacquisitions depends upon Hiland Partners’ future operating performance and,more broadly, on the availability of equity and debt financing, which will beaffected by prevailing economic conditions in Hiland Partners’ industry andfinancial, business and other factors, many of which are beyond Hiland Partners’control. Due to (i) the impact of lower commodity prices and drillingactivity on Hiland Partners’ current and projected throughput volumes,midstream segment margin and cash flows; (ii) future required levels ofcapital expenditures; (iii) the level of Hiland Partners’ indebtednessrelative to its projections and (iv) management’s expectation that HilandPartners may be in violation of the 

 

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maximumconsolidated funded debt to EBITDA covenant ratio contained in its seniorsecured credit facility as early as September 30, 2009, unless the ratiois amended, Hiland Partners receives an infusion of equity capital,  Hiland Partners’ debt is restructured orHiland Partners is able to monetize “in-the-money” hedges positions.  Hiland Partners has suspended quarterly cashdistributions on common and subordinated units beginning with the first quarterdistribution of 2009.

 

***CashFlows from Operating Activities***

 

Cash flows from operating activities increased by $2.5 million to $24.5million for the six months ended June 30, 2009 from $22.0 million for thesix months ended June 30, 2009.  During the six months ended June 30,2009 we received cash flows from customers of approximately $108.4 millionattributable to significantly lower average realized natural gas and NGL salesprices, partially offset by increased natural gas and NGLs volumes, received$3.2 million from early settlements of derivative contracts, made cash paymentsto our suppliers and employees of approximately $81.9 million and made paymentsof interest expense of $5.2 million, net of amounts capitalized, resulting incash received from operating activities of $24.5 million.  During the same six month period in 2008, wereceived cash flows from customers of approximately $184.3 million attributableto increased natural gas and NGLs volumes and significantly higher averagerealized natural gas and NGL sales prices, had cash payments to our suppliersand employees of approximately $155.9 million and payment of interest expenseof $6.4 million, net of amounts capitalized, resulting in cash received fromoperating activities of $22.0 million.

 

Changes in cash receipts and payments are primarily due to the timingof collections at the end of our reporting periods. Hiland Partners collectsand pays large receivables and payables at the end of each calendar month. Thetiming of these payments and receipts may vary by a day or two betweenmonth-end periods and cause fluctuations in cash received or paid. Workingcapital items, exclusive of cash, provided $5.0 million of cash flows fromoperating activities during the six months ended June 30, 2009. Workingcapital items, exclusive of cash, used $5.0 million of cash flows fromoperating activities during the six months ended June 30, 2008.

 

Net loss for the six months ended June 30, 2009 was $(7.0)million, a increase in net loss of $4.4 million from a net loss of $(2.7)million for the six months ended June 30, 2008.  Depreciation,amortization, accretion and property impairments increased by $3.4 million to $22.0million for the six months ended June 30, 2009 from $18.7 million for thesix months ended June 30, 2008.

 

***CashFlows Used for Investing Activities***

 

Cash flows used for investing activities, which represent investmentsin property and equipment increased by $6.9 million to $27.2 million for thesix months ended June 30, 2009 from $20.3 million for the six months endedJune 30, 2008 primarily due to cash flows invested related to theconstruction of the North Dakota Bakken gathering system.

 

***CashFlows from Financing Activities***

 

Cash flows from financing activities increased to $5.2 million for thesix months ended June 30, 2009 from $1.4 million for the six months ended June 30,2008, an increase of $3.8 million. During the six months ended June 30, 2009,Hiland Partners (i) borrowed $12.0 million under its credit facility tofund its internal expansion projects, (ii) repaid $3.0 million on itscredit facility upon net receipt of $3.2 million early hedge settlements, (iii) distributed$1.8 million to its noncontrolling partners and (iv) made $0.4million payments on capital lease obligations. During the six months ended June 30,2009, we borrowed $0.5 million on our credit facility and made distributions of$2.2 million to our unitholders.

 

During the six months ended June 30, 2008, Hiland Partners (i) borrowed$19.0 million under its credit facility to fund its internal expansionprojects, (ii) received capital contributions of $1.0 million as a resultof issuing Hiland Partners common units due to the exercise of 40,705 vested unit options, (iii) incurred debtissuance costs of $0.3 million associated with the fourth amendment to itscredit facility amended in February 2008, (iv) distributed$6.4 million to its minority interest unitholders and (v) made $0.2million payments on capital lease obligations. During the six months ended June 30,2008, we made distributions of $11.6 million to our unitholders.

 

***CapitalRequirements***

 

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

 

·         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

 

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

 

We believe that cash generated from the operations of Hiland Partners’business will be sufficient to meet its anticipated maintenance capitalexpenditures for the next twelve months. We anticipate that Hiland Partners’ expansion capital expenditures willbe funded through long-term borrowings or other debt financings and/or equityofferings. See “Credit Facility” below for information related to our andHiland Partners’ credit agreements.

 

Hiland Partnerssuspended quarterly cash distributions on common and subordinated unitsbeginning with the first quarter distribution of 2009.  As our only cash-generating assets are our 2%general partner interest, all of the incentive distribution rights and a 57.4%limited partner interest in Hiland Partners, our cash flow is completelydependent upon the ability of Hiland Partners to make cash distributions to itspartners, including us.  Our creditfacility matures on December 31, 2009, at which time all outstanding amountsthereunder will become due and payable. We believe the current availability on the credit facility will allow usto meet our current obligations and future expenses through maturity.  We cannot assure that any refinancing of ourcredit facility can be successfully completed or, if completed, that the termswill be favorable to us.  If we areunable to obtain a refinancing of our outstanding debt and Hiland Partners doesnot resume paying quarterly cash distributions in amounts necessary to satisfyour obligations, we may need to sell common units in Hiland Partners to satisfyour outstanding debt obligations and any current liabilities that we may incurin the operation of our business in the future.

 

***NorthDakota Bakken***

 

Hiland Partners’ North Dakota Bakken gathering system presentlyconsists of a 55-mile gathering system located in northwestern North Dakotathat will gather natural gas associated with crude oil produced from the Bakkenshale and Three Forks/Sanish formations. Construction of the gathering system,associated compression and treating facilities and a processing plant commencedin October 2008 and became fully operational in May 2009.  As of June 30, 2009, Hiland Partners hasinvested approximately $22.9 million in the project.

 

***FinancialDerivatives and Commodity Hedges***

 

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

 

The following table provides information about Hiland Partnerscommodity based derivative instruments at June 30, 2009:

 

| ** **                                         | ** ** | ** **  | ** ** | **Average**     | ** ** | ** **     | ** ** |
|----------------------------------------------------|------------|-------------|------------|-----------------|------------|----------------|------------|
| ** **                                         | ** ** | ** **  | ** ** | **Fixed**       | ** ** | **Fair Value** | ** ** |
| **Description  and Production Period**             | ** ** | **Volume**  | ** ** | **Price**       | ** ** | **Asset**      | ** ** |
| ** **                                         | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **     | ** ** |
| Natural Gas - Sold Fixed  for Floating Price Swaps |       |        |       |            |       |           |       |
| July 2009 -  June 2010                   |       | 2,136,000   |       | $               | 7.01       |           | $          | 6,188 |   |
| July 2010 -  December 2010               |       | 1,068,000   |       | $               | 6.73       |           | 1,450      |   |
|                                               |       |        |       |            |       | $              | 7,638      |   |

 

Hiland Partners has entered into a financial derivative instrument thatis classified as a cash flow hedge in accordance with SFAS 133 and relates toforecasted interest payments under its credit facility in 2009.  Hiland Partners entered into this financialswap instrument to hedge forecasted interest payments against the variableinterest payments under its credit facility. Under this contractual swap agreement, Hiland Partners pays a fixedinterest rate and receives a floating rate based on one month LIBOR on thenotional amount for the contract period. The following table providesinformation about Hiland Partners interest rate swap at June 30, 2009 forthe periods indicated:

 

| ** **                           | ** ** | ** **   | ** ** | ** **   | ** ** | **Fair Value**  | ** ** |
|--------------------------------------|------------|--------------|------------|--------------|------------|-----------------|------------|
| ** **                           | ** ** | **Notional** | ** ** | **Interest** | ** ** | **Asset**       | ** ** |
| **Description  and Period**          | ** ** | **Amount**   | ** ** | **Rate**     | ** ** | **(Liability)** | ** ** |
| Interest Rate Swap                   |       |         |       |         |       |            |       |
| July 2009 -  December 2009 |       | $            | 100,000    |         | 2.245      | %               | $          | (921 | ) |
|                                      |            |              |            |              |            |                 |            |  |  |

 

***Off-BalanceSheet Arrangements***

 

Neither we nor Hiland Partners had any significant off-balance sheetarrangements as of June 30, 2009.

 

***AvailableCredit***

 

Credit markets in the United States and around the world remainconstrained due to a lack of liquidity and confidence in a number of financialinstitutions. Investors continue to seek perceived safe investments insecurities of the United States government rather than corporate issues. We andHiland Partners may at times experience difficulty accessing the long-termcredit markets due to prevailing market conditions. Additionally, existingconstraints in the credit markets may increase the rates we and Hiland Partnersis charged for utilizing these markets.

 

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***Credit Facilities***

 

***Hiland Holdings Credit Facility***

 

On September 25, 2006, concurrently with the closing of our initialpublic offering, we entered into a three-year $25.0 million senior securedcredit facility. Pursuant to the terms of the agreement, we elected to reducethe commitment level on the credit facility to $10.0 million effective May 15,2009 and we elected to further reduce the commitment level on the creditfacility to $3.0 million on August 7, 2009. Concurrently with the reduction of the commitment level to $3.0 million,the existing lenders under the credit facility assigned their interests in thefacility to The Security National Bank of Enid and we entered into a firstamended and restated senior secured credit agreement with The Security NationalBank of Enid.  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 facilitywill mature on December 31, 2009, at which time all outstanding amounts thereunderbecome due and payable.

 

Indebtedness under the credit facility bears interest at the prime rateplus 1% per annum, but in no event less than 5% per annum, to be adjusted aschanges occur in the prime rate.  AtAugust 7, 2009, the interest rate on outstanding borrowings from our creditfacility was 5.0%.

 

The credit facility contains several covenants that, among otherthings, require the maintenance of a debt-to-worth ratio and require financialreports to be submitted periodically. The credit facility also contains various covenants that limit, amongother things, subject to certain exceptions, our ability to grant liens, enterinto agreements restricting our ability to grant liens on our assets or amendthe credit facility, make certain loans, acquisitions and investments or enterinto a merger, consolidation or sale of assets.

 

The amount we may borrow under the credit facility is limited to thelesser of: (i) 50% of the sum of the value of the Hiland Partners common andsubordinated units and (ii) the maximum available amount of the credit facility(currently $3.0 million).  For purposesof this calculation, the value of (i) the Hiland Partners common units on anydate shall be the closing price for such units as reflected on the NASDAQNational Market on any date and (ii) the Hiland Partners subordinated units onany date shall be deemed to equal 85% of the value of the Hiland Partnerscommon units on such date.  At August 7,2009, the borrowing base was $3.0 million.

 

As of August 7, 2009, we had $2.5 million outstanding under this creditfacility and were in compliance with our debt-to-worth ratio covenant. As of June 30,2009, we had $1.2 million outstanding under our prior credit facility andwere in compliance with our financial covenants. The outstanding$1.2 million at June 30, 2009, which now matures on December 31, 2009, isincluded in accrued liabilities and other in the balance sheet.

 

***Hiland Partners Credit Facility***

 

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

 

In addition, Hiland Partners’ senior secured revolving credit facilityprovides for an accordion feature, which permits Hiland Partners, if certainconditions are met, to increase the size of the Acquisition Facility by up to$50 million and allows for the issuance of letters of credit of up to$15 million in the aggregate. The senior secured revolving credit facilityalso requires Hiland Partners to 

 

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meet certainfinancial tests, including a maximum consolidated funded debt to EBITDA ratioof 4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscalquarters following the quarter in which such acquisition or capital expenditureoccurs; and a minimum interest coverage ratio of 3.0:1.0.  The credit facility will mature in May 2011.At that time, the agreement will terminate and all outstanding amountsthereunder will be due and payable.

 

Due to lower natural gas and NGL prices and the impact of reduceddrilling activity on Hiland Partners’ current and projected throughput volumes,Hiland Partners believes that cash generated from operations will decrease forthe remainder of 2009 relative to comparable periods in 2008.  Hiland Partners’ senior secured revolvingcredit facility requires Hiland Partners to meet certain financial tests,including a maximum consolidated funded debt to EBITDA covenant ratio of4.0:1.0 as of the last day of any fiscal quarter; provided that in the eventthat Hiland Partners makes certain permitted acquisitions or capitalexpenditures, this ratio may be increased to 4.75:1.0 for the three fiscalquarters following the quarter in which such permitted acquisition or capitalexpenditure occurs.  Hiland Partners metthe permitted capital expenditure requirements for the four quarter periodended March 31, 2009 and elected to increase the ratio to 4.75:1.0 on March 31,2009 for the quarters ended March 31, 2009, June 30, 2009 and September 30,2009.  During this step-up period, theapplicable margin with respect to loans under the credit facility increases by35 basis points per annum and the unused commitment fee increases by 12.5 basispoints per annum. The ratio will revert back to 4.0:1.0 for the quarter ended December 31,2009.  If commodity prices do notsignificantly improve above the current forward prices for 2009, HilandPartners could be in violation of the maximum consolidated funded debt toEBITDA covenant ratio as early as September 30, 2009, unless this ratio isamended, Hiland Partners receives an infusion of equity capital, HilandPartners’ debt is restructured or Hiland Partners is able to monetize “in-the-money”hedge positions.  Management iscontinuing extensive discussions with certain lenders under the credit facilityas to ways to address a potential covenant violation. While no potentialsolution has been agreed to, Hiland Partners expects that any solution willrequire the assessment of fees and increased rates, the infusion of additionalequity capital or the incurrence of subordinated indebtedness by HilandPartners and the suspension of distributions for a certain period of time.There can be no assurance that any such agreement will be reached with thelenders, that any required equity or debt financing will be available to HilandPartners, or that Hiland Partners’ hedge positions will be “in-the-money.”

 

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

 

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

 

Indebtedness under the credit facility will bear interest, at HilandPartners’ option, at either; (i) an Alternate Base Rate plus an applicablemargin ranging from 50 to 125 basis points per annum or (ii) LIBOR plus anapplicable margin ranging from 150 to 225 basis points per annum based onHiland Partners’ ratio of consolidated funded debt to EBITDA. The AlternateBase Rate is a rate per annum equal to the greatest of (a) the Prime Ratein effect on such day, (b) the base CD rate in effect on such day plus1.50% and (c) the Federal Funds effective rate in effect on such day plus1⁄2 of 1%. Hiland Partners has elected for the indebtedness to bear interest atLIBOR plus the applicable margin.  Aletter of credit fee will be payable for the aggregate amount of letters ofcredit issued under the credit facility at a percentage per annum equal to1.0%. An unused commitment fee ranging from 25 to 50 basis points per annumbased on Hiland Partners’ ratio of consolidated funded debt to EBITDA will bepayable on the unused portion of the credit facility. During the step-upperiod, the applicable margin with respect to loans under the credit facilitywill be increased by 35 basis points per annum and the unused commitment feewill be increased by 12.5 basis points per annum.  At June 30, 2009, the interest rate onoutstanding borrowings from Hiland Partners’ credit facility was 2.92%.

 

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

 

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

 

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

 

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

 

As of June 30, 2009, Hiland Partners had $261.1 millionoutstanding under the credit facility and was in compliance with its financialcovenants.  Hiland Partners’ EBITDA tointerest expense ratio was 4.95 to 1.0 and its consolidated funded debt toEBITDA ratio was 4.40 to 1.0.

 

***Impact of Inflation***

 

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

 

***Recent Accounting Pronouncements***

 

On June 30, 2009, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 168, “**The****FASB Accounting Standards Codification**TM******andThe Hierarchy of Generally Accepted Accounting Principles” (“FASB ASC”), areplacement of SFAS No. 162, “The Hierarchy of Generally AcceptedAccounting Principles”.** On the effective date, FASB****ASC became the source of authoritativeU.S. accounting and reporting standards for nongovernmental entities, inaddition to guidance issued by the SEC,and preparers must begin to use the Codification forperiods that begin on or about July 1, 2009. All existing accountingstandard documents are superseded and all other accounting literature notincluded in the Codification will be considered nonauthoritative. FASB ASC significantlychanges the way financial statement preparers, auditors, and academics performaccounting research.The FASB expects that FASB ASC will reduce the amount of time andeffort required to research an accounting issue, mitigate the risk of noncompliancewith standards through improved usability of the literature, provide accurateinformation with real-time updates as new standards are released, and assistthe FASB with the research efforts required during the standard-settingprocess. FASB ASC was adopted effective July 1, 2009 and will not have amaterial impact on our financial statements and disclosures therein.

 

On May 28, 2009, the FASB issued FASB Statement No. 165,“**Subsequent**Events(“SFAS 165”). SFAS 165 requires entities to disclose the date through which they haveevaluated subsequent events and whether the date corresponds with the releaseof their financial statements. SFAS 165 is effective for interim and annualperiods ending after June 15, 2009. SFAS No. 165 was adopted effective June 30, 2009 and did nothave a material impact on our financial statements and disclosures therein.

 

On April 9, 2009, the FASB issued Staff Position No. FAS107-1 and APB 28-1, “Interim Disclosures about Fair Value of FinancialInstruments” (“FAS107-1”).  FAS107-1increases the frequency of fair value disclosures to a quarterly basis insteadof annual basis.  FAS107-1 specificallyrelates to fair value disclosures for any financial instruments that are notcurrently reflected on the balance sheet at fair value.   FAS107-1 is effective for interim and annualperiods ending after June 15, 2009. FAS107-1 was adopted effective June 30, 2009 and did not have amaterial impact on our financial statements and disclosures therein.

 

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

 

On April 25, 2008, the FASB issued Staff Position No. FAS142-3, “Determination of the UsefulLife of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that an entity shouldconsider in developing renewal or extension assumptions used in determining theuseful life of recognized intangible assets under FASB Statement No. 142 (“SFAS142”), “Goodwill and Other IntangibleAssets”. In determining the useful life of an acquired intangible asset,FSP 142-3 removes the requirement from SFAS 142 for an entity to considerwhether renewal of the intangible asset requires significant costs or materialmodifications to the related arrangement. FSP 142-3 also replaces the previoususeful life assessment criteria with a requirement that an entity considers itsown experience in renewing similar arrangements. If the entity has no relevantexperience, it would consider market participant assumptions regardingrenewal.  FSP 142-3 was adopted effective January 1, 2009 and willapply to future intangible assets acquired. We don’t believe the adoption of FSP 142-3 will have a material impacton our financial position, results of operations or cash flows.

 

On March 19, 2008, the FASB issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities”, an amendment of SFAS 133(“SFAS 161”). SFAS 161 is intended to improve transparency in financialreporting by requiring enhanced disclosures of an entity’s derivativeinstruments and hedging activities and their effects on the entity’s financialposition, financial performance, and cash flows. SFAS 161 is effectiveprospectively for financial statements issued for fiscal years and interimperiods 

 

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beginning after November 15,2008, with early application encouraged. SFAS 161 encourages, but does notrequire, comparative disclosures for periods prior to its initial adoption.SFAS 161 amended the qualitative and quantitative disclosure requirements forderivative instruments and hedging activities set forth in SFAS 133 andgenerally increased the level of aggregation/disaggregation required in anentity’s financial statements. SFAS 161 was adopted effective January 1,2009 and did not have a material impact on our financial statements anddisclosures therein.

 

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

 

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

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS159 expands opportunities to use fair value measurement in financial reportingand permits entities to choose to measure many financial instruments andcertain other items at fair value. SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007. SFAS 159 was adopted effective January 1,2008, at which time no financial assets or liabilities, not previously requiredto be recorded at fair value by other authoritative literature, were designatedto be recorded at fair value.  As such,the adoption of SFAS 159 did not have any impact on our financial position,results of operations or cash flows.

 

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

 

In December 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51”(“SFAS 160”). SFAS 160 establishes accounting and reporting standards thatrequire the ownership interests in subsidiaries held by parties other than theparent (minority interest) be clearly identified, labeled and presented in theconsolidated balance sheet within equity, but separate from the parent’sequity. SFAS 160 requires the equity amount of consolidated net incomeattributable to the parent and to the noncontrolling interest be clearlyidentified and presented on the face of the consolidated income statement andthat changes in a parent’s ownership interest while the parent retains itscontrolling financial interest in its subsidiary be accounted for consistentlyand similarly as equity transactions. Consolidated net income and comprehensiveincome are now determined without deducting minority interest; however,earnings-per-share information continues to 

 

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be calculated onthe basis of the net income attributable to the parent’s shareholders.  Additionally, SFAS 160 establishes a singlemethod for accounting for changes in a parent’s ownership interest in asubsidiary that does not result in deconsolidation and that the parentrecognize a gain or loss in net income when a subsidiary isdeconsolidated.  SFAS 160 is effectivefor fiscal years beginning on or after December 15, 2008. SFAS 160 wasadopted effective January 1, 2009 and did not have a material impact onour financial position, results of operations or cash flows.

 

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

 

Upon adoption of SFAS 160 effective January 1, 2009, wereclassified $125,851 from minority interests liabilities to noncontrollingpartners’ interest in Hiland Partners in our consolidated balance sheet as of December 31,2008.  In addition, we reclassified $2,192 and $2,398 of minority interestin loss of Hiland Partners to net loss attributable to noncontrolling partners’interest in loss of Hiland Partners in our consolidated statement of operationsfor the three and six months ended June 30, 2008, respectively.  Netincome per limited partner unit has not been affected as a result of theadoption of SFAS 160.

 

***SignificantAccounting Policies and Estimates***

 

The selection and application of accounting policies is an importantprocess that has developed as our business activities have evolved and as theaccounting rules have developed.  Accounting rules generally donot involve a selection among alternatives, but involve the implementation andinterpretation of existing rules, and the use of judgment applied to thespecific set of circumstances existing in our business.  We make everyeffort to properly comply with all applicable rules on or before theiradoption, and we believe the proper implementation and consistent applicationof the accounting rules are critical.

 

There have been no material changes in our significant accountingpolicies and estimates during the three months ended June 30, 2009.  See our disclosure of significant accountingpolicies and estimates in Item 7. “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” on our Annual Report on Form 10-K forthe year ended December 31, 2008, filed with the SEC on March 9,2009.

 

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

 

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

 

***Commodity Price Risks.  *** Hiland Partners’ profitability is affected byvolatility in prevailing NGL and natural gas prices. Historically, changes inthe prices of most NGL products have generally correlated with changes in theprice of crude oil. NGL and natural gas prices are volatile and are impacted bychanges in the supply and demand for NGLs and natural gas, as well as marketuncertainty. Hiland Partners’ cash flow is affected by the volatility ofnatural gas and NGL product prices, which could adversely affect our ability tomake distributions to unitholders. To illustrate the impact of changes inprices for natural gas and NGLs on our operating results, we have provided thetable below, which reflects, for the three months ended June 30, 2009 and June 30,2008, respectively, the impact on our midstream segment margin of a $0.01 pergallon change (increase or decrease) in NGL prices coupled with a $0.10 perMMBtu change (increase or decrease) in the price of natural gas.

 

|                          |       | **Natural  Gas Price Change ($/MMBtu)  Three Months Ended June 30,** |       |
|-------------------------------|------------|---------------------------------------------------------------------------|------------|
|                          |       | **2009**                                                                  |       | **2008** |   |
| **NGL  Price Change ($/gal)** | ** ** | **$0.10**                                                                 | ** ** | **$(0.10)** | ** ** | **$0.10** | ** ** | **$(0.10)** | ** ** |
| $                             | 0.01       |                                                                      | $          | 163,000 |   | $ | 181,000 |   | $ | 151,000 |   | $ | 142,000 |   |
| $                             | (0.01      | )                                                                         | $          | (213,000 | ) | $ | (216,000 | ) | $ | (127,000 | ) | $ | (189,000 | ) |

 

The increase in commodity exposure is the result of increased naturalgas and NGL product volumes during the three months ended June 30, 2009compared to the three months ended June 30, 2008 and the increasedexposure to NGL product prices in 2009 as 

 

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the result of noNGL hedging contracts in 2009. The magnitude of the impact on total segmentmargin of changes in natural gas and NGL prices presented may not berepresentative of the magnitude of the impact on total segment margin fordifferent commodity prices or contract portfolios. Natural gas and crude oilprices can also affect our profitability indirectly by influencing the level ofdrilling activity and related opportunities for our services.

 

We manage this commodity price exposure through an integrated strategythat includes management of our contract portfolio, optimization of our assetsand the use of derivative contracts. As a result of these derivative swapcontracts, we have hedged a portion of our expected exposure to natural gasprices in 2009 and 2010. We continually monitor our hedging and contractportfolio and expect to continue to adjust our hedge position as conditionswarrant. The following table provides information about our commodity-basedderivative instruments at June 30, 2009 for the periods indicated:

 

| ** **                                         | ** ** | ** **  | ** ** | **Average**     | ** ** | ** **     | ** ** |
|----------------------------------------------------|------------|-------------|------------|-----------------|------------|----------------|------------|
| ** **                                         | ** ** | ** **  | ** ** | **Fixed**       | ** ** | **Fair Value** | ** ** |
| **Description  and Production Period**             | ** ** | **Volume**  | ** ** | **Price**       | ** ** | **Asset**      | ** ** |
| ** **                                         | ** ** | **(MMBtu)** | ** ** | **(per MMBtu)** | ** ** | ** **     | ** ** |
| Natural Gas - Sold Fixed  for Floating Price Swaps |       |        |       |            |       |           |       |
| July 2009 -  June 2010                   |       | 2,136,000   |       | $               | 7.01       |           | $          | 6,188 |   |
| July 2010 -  December 2010               |       | 1,068,000   |       | $               | 6.73       |           | 1,450      |   |
|                                               |       |        |       |            |       | $              | 7,638      |   |

 

***Interest Rate Risk.***   We are exposed to changes in the LIBORrate as a result of Hiland Partners’ credit facility, and the prime rate as aresult of our credit facility, which are both subject to floating interestrates.  On October 7, 2008, Hiland Partners entered into a floating-to-fixed interest rate swap agreementwith an investment grade counterparty whereby Hiland Partners pays a monthlyfixed interest rate of 2.245% and receives a monthly variable rate based on theone month posted LIBOR interest rate on a notional amount of $100.0million.  This swap agreement waseffective on January 2, 2009 and terminates on January 1, 2010.  As of June 30, 2009, Hiland Partners hadapproximately $261.1 million of indebtedness outstanding under its creditfacility, of which $161.1 million is exposed to changes in the LIBOR rate. Theimpact of a 100 basis point increase in interest rates on the amount of currentdebt exposed to variable interest rates would for the remainder of 2009, resultin an increase in annualized interest expense and a corresponding decrease inannualized net income of approximately $1.6 million. The following table providesinformation about Hiland Partners’ interest rate swap at June 30, 2009 forthe periods indicated:

 

| ** **                           | ** ** | ** **   | ** ** | ** **   | ** ** | **Fair Value**  | ** ** |
|--------------------------------------|------------|--------------|------------|--------------|------------|-----------------|------------|
| ** **                           | ** ** | **Notional** | ** ** | **Interest** | ** ** | **Asset**       | ** ** |
| **Description  and Period**          | ** ** | **Amount**   | ** ** | **Rate**     | ** ** | **(Liability)** | ** ** |
| Interest Rate Swap                   |       |         |       |         |       |            |       |
| July 2009 -  December 2009 |       | $            | 100,000    |         | 2.245      | %               | $          | (921 | ) |
|                                      |            |              |            |              |            |                 |            |  |  |

 

***Credit Risk.****  *Counterparties pursuant to the terms of their contractual obligations exposeHiland Partners to potential losses as a result of nonperformance. HilandPartners’ four largest customers for the six months ended June 30, 2009accounted for approximately 20%, 15%, 11% and 10%, respectively, of revenues.Consequently, changes within one or more of these companies’ operations havethe potential to impact, both positively and negatively, our credit exposureand make us subject to risks of loss resulting from nonpayment ornonperformance by these or any of Hiland Partners’ other customers. Anymaterial nonpayment or 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 of June 30, 2009 are BP Energy Companyand Bank of Oklahoma, N.A. Our counterparty to our interest rate swap as of June 30,2009 is Wells Fargo Bank, N.A.

 

On July 22, 2008,SemGroup, L.P. and certain subsidiaries filed voluntary petitions forreorganization under Chapter 11 of the U.S. Bankruptcy Code.  In October 2008, the United StatesBankruptcy Court for the District of Delaware entered an order approving theassumption of a Natural Gas Liquids Marketing Agreement (the “SemStreamAgreement”) between SemStream, L.P., an affiliate of SemGroup, L.P., and HilandPartners relating to the sale of natural gas liquids and condensate at ourBakken and Badlands plants and gathering systems, restoring Hiland Partners andSemStream, L.P. to its pre-bankruptcy contractual relationship.  Hiland Partners pre-petition credit exposureto SemGroup, L.P. relating to condensate sales to SemCrude, LLC in ourmid-continent region is approximately $0.3 million, which continues to bereserved as of June 30, 2009.

 

**Item 4. Controls and Procedures**

 

**Evaluation of Disclosure Controls and Procedures**

 

(a)   Evaluationof disclosure controls and procedures.

 

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Asrequired by Rule 13a-15(b) under the Securities Exchange Act of 1934,as amended, we have evaluated, under the supervision and with the participationof our management, including our principal executive officer and principalfinancial officer, the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act) as of the end of the period covered bythis Quarterly Report on Form 10-Q. Based upon that evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures were effective as of June 30, 2009, toensure that information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure and isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the SEC.

 

(b) Changes in internal control over financial reporting.

 

Duringthe three months ended June 30, 2009, there were no changes in our systemof internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

**PART II OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

Three putative unitholder class action lawsuits have been filedrelating to the Hiland Partners Merger and the Hiland Holdings Merger.  These lawsuits are as follows: (i) *Robert Pasternack v. Hiland Partners, LP et al.*, In theCourt of Chancery of the State of Delaware, Civil Action No. 4397-VCS; (ii) *Andrew Jones v. Hiland Partners, LP et al.*, In the Court ofChancery of the State of Delaware, Civil Action No. 4558-VCS; and (iii) *Arthur G. Rosenberg v. Hiland Partners, LP et al.*, In theDistrict Court of Garfield County, State of Oklahoma, Case No. C3-09-211-02.  The lawsuits name as defendants thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and the members of the board of directors of each of thePartnership and Hiland Partners.   Thelawsuits challenge both the Hiland Partners Merger and the Hiland HoldingsMerger.  The lawsuits allege claims ofbreach of the Partnership Agreement and breach of fiduciary duty on behalf of (i) apurported class of common unitholders of the Partnership and (ii) apurported class of our common unitholders of Hiland Partners.

 

On July 10, 2009, the court in which the Oklahoma case is pendinggranted our motion to stay the Oklahoma lawsuit in favor of the Delawarelawsuits.   On July 31, 2009, theplaintiff in the first-filed Delaware case (*Pasternack*) filedan Amended Class Action Complaint and a motion to enjoin the mergers.   This Amended Class Action Complaintalleges, among other things, that (i) the original consideration andrevised consideration offered by the Hamm Parties is unfair and inadequate, (ii) themembers of the conflicts committees of the general partner of each of thePartnership and Hiland Partners that were charged with reviewing the proposalsand making a recommendation to each committee’s respective board of directorslacked any meaningful independence, (iii) the defendants acted in badfaith in recommending and approving the Hiland Partners Merger or the HilandHoldings Merger, and (iv) the disclosures in the Preliminary ProxyStatement filed by the Partnership and Hiland Partners are materiallymisleading.   The *Pasternack*plaintiffseeks to preliminarily enjoin the defendants from proceeding with orconsummating the mergers and seeks an order requiring defendants to supplementthe Preliminary Proxy Statement with certain information.  We cannot predict the outcome of theselawsuits, or others, nor can we predict the amount of time and expense thatwill be required to resolve the lawsuits.

 

Additional information concerning these lawsuits may be found in thePreliminary Proxy Statement filed by the Partnership and Hiland Partners and,when filed, in the definitive joint proxy statement.

 

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

 

**Item 1A. Risk Factors**

 

***The failure to complete the Hiland Holdings Merger could adverselyaffect the price of our common units and otherwise have an adverse effect onus.***

 

There can be no assurance that the conditions to the completion of theHiland Holdings Merger, many of which are out of our control, will be satisfiedby the November 1, 2009 deadline set forth in the merger agreement.   Among other things, we cannot be certainthat (i) holders of a majority of our common units (other than Mr. Hamm,certain of his affiliates and the Hamm family trusts) will vote in favor of theHiland Holdings Merger and the merger agreement; (ii) no injunction willbe granted in any of the three pending unitholder lawsuits challenging theHiland Holdings Merger (as described elsewhere in this Form 10-Q); or (iii) thatthe 

 

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Hiland PartnersMerger will be completed concurrently with the Hiland Holdings Merger (thecompletion of which is a condition to Mr. Hamm’s obligation to completethe Hiland Holdings Merger).

 

If the Hiland Holdings Merger is not completed, the price of our commonunits will likely fall to the extent that the current market price of ourcommon units reflects an assumption that a transaction will be completed.Further, a failed transaction may result in negative publicity and/or anegative impression of us in the investment community and may affect ourrelationship with employees, vendors, creditors and other business partners.

 

Additionally, we are subject to the following risks related to theHiland Holdings Merger:

 

·      Certaincosts relating to the Hiland Holdings Merger, including legal, accounting andfinancial advisory fees, are payable by us whether or not the Hiland HoldingsMerger is completed.

 

·      Under circumstances set out in the mergeragreement, if the Hiland Holdings Merger is not completed we may be required toreimburse up to $800,000 availability ofMr. Hamm and his affiliate’s expenses associated with the Hiland Holdings Merger.

 

·      Our management’s and our employees’attention will have been diverted from our day-to-day operations, we mayexperience unusually high employee attrition and our business and customerrelationships may be disrupted.

 

***We are subject to litigation related to the Hiland Holdings Merger.***

 

We are actively defending three putative unitholder class actionlawsuits which have been filed relating to the Hiland Partners Merger and theHiland Holdings Merger.  These lawsuitsare as follows: (i) *Robert Pasternack v.Hiland Partners, LP et al.*, In the Court of Chancery of the State ofDelaware, Civil Action No. 4397-VCS; (ii) *Andrew Jonesv. Hiland Partners, LP et al.*, In the Court of Chancery of the Stateof Delaware, Civil Action No. 4558-VCS; and (iii) *Arthur G. Rosenberg v. Hiland Partners, LP et al.*, In theDistrict Court of Garfield County, State of Oklahoma, Case No. C3-09-211-02.  The lawsuits name as defendants thePartnership, Hiland Partners, the general partner of each of the Partnershipand Hiland Partners, and the members of the board of directors of each of thePartnership and Hiland Partners.   Thelawsuits challenge both the Hiland Partners Merger and the Hiland HoldingsMerger.  The lawsuits allege claims ofbreach of the Partnership Agreement and breach of fiduciary duty on behalf of (i) apurported class of common unitholders of the Partnership and (ii) apurported class of our common unitholders of Hiland Partners.

 

On July 10, 2009,the court in which the Oklahoma case is pending granted our motion to stay theOklahoma lawsuit in favor of the Delaware lawsuits.   On July 31, 2009, the plaintiff in thefirst-filed Delaware case (Pasternack) filed an Amended Class ActionComplaint and a motion to enjoin the mergers.  This Amended Class Action Complaint alleges, among other things,that (i) the original consideration and revised consideration offered bythe Hamm Parties is unfair and inadequate, (ii) the members of theconflicts committees of the general partner of each of the Partnership andHiland Partners that were charged with reviewing the proposals and making arecommendation to each committee’s respective board of directors lacked anymeaningful independence, (iii) the defendants acted in bad faith inrecommending and approving the Hiland Partners Merger or the Hiland HoldingsMerger, and (iv) the disclosures in the Preliminary Proxy Statement filedby the Partnership and Hiland Partners are materially misleading.   The Pasternack plaintiff seeks topreliminarily enjoin the defendants from proceeding with or consummating themergers and seeks an order requiring defendants to supplement the PreliminaryProxy Statement with certain information. It is possible that additional claims beyond those that have alreadybeen filed will be brought by the current plaintiffs or by others in an effortto enjoin the Hiland Holdings Merger or seek monetary relief from us.

 

While the Hiland Companies do not believe these lawsuits have merit andintend to defend themselves vigorously, we cannot predict the outcome of theselawsuits, or others, nor can we predict the amount of time and expense thatwill be required to resolve the lawsuits. An unfavorable resolution of any such litigation surrounding the HilandHoldings Merger could delay or prevent the consummation of the Hiland HoldingsMerger. In addition, the cost to us of defending the litigation, even ifresolved in our favor, could be substantial. Such litigation could also divertthe attention of our management and our resources in general from day-to-dayoperations.

 

***If commodity prices do not significantly improve above theexpected prices for 2009, Hiland Partners may be in violation of its maximumconsolidated funded debt to EBITDA covenant ratio as early as September 30,2009, unless the ratio is amended, its senior secured revolving credit facilityis restructured, Hiland Partners receives an infusion of equity capital orHiland Partners is able to monetize “in-the-money” hedge positions. Failure tocomply with the covenants could cause an event of default under the HilandPartners credit facility.***

 

The HilandPartners credit facility contains covenants requiring Hiland Partners tomaintain certain financial ratios and comply with certain financial tests,which, among other things, require Hiland Partners and its subsidiaryguarantors, on a consolidated basis, 

 

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to maintain specifiedratios or conditions as follows:

 

·      EBITDAto interest expense of not less than 3.0 to 1.0; and

 

·      consolidatedfunded debt to EBITDA of not more than 4.0 to 1.0 with the option to increasethe consolidated funded debt to EBITDA ratio**to not more than 4.75 to 1.0 for a period of up to nine monthsfollowing an acquisition or a series of acquisitions totaling $40 million in a12-month period (subject to an increased applicable interest rate margin andcommitment fee rate).

 

As of June 30, 2009,Hiland Partners was in compliance with each of these ratios, which are testedquarterly. Hiland Partners’ EBITDA to interest expense ratio was 4.95 to 1.0and its consolidated funded debt to EBITDA covenant ratio was 4.40 to 1.0.Hiland Partners temporarily increased the ratio to 4.75:1.0 on March 31, 2009,but such ratio will be reduced to 4.0:1.0 on December 31, 2009. HilandPartners’ ability to remain in compliance with these restrictions and covenantsin the future is uncertain and will be affected by the levels of cash flow fromour operations and events or circumstances beyond our control. If commodityprices do not significantly improve above the expected prices for 2009, HilandPartners may be in violation of the maximum consolidated funded debt to EBITDAratio as early as September 30, 2009, unless the ratio is amended, thesenior secured revolving credit facility is restructured,  Hiland Partners receives an infusion ofequity capital or Hiland Partners is able to monetize “in-the-money” hedgepositions. Hiland Partners’ failure to comply with any of the restrictions andcovenants under our revolving credit facility could lead to an event of defaultand the acceleration of our obligations under those agreements. Hiland Partnersmay not have sufficient funds to make such payments. If Hiland Partners isunable to satisfy its obligations with cash on hand, Hiland Partners couldattempt to refinance such debt, sell assets or repay such debt with theproceeds from an equity offering. We cannot assure that Hiland Partners will beable to generate sufficient cash flow to pay the interest on its debt or thatfuture borrowings, equity financings or proceeds from the sale of assets willbe available to pay or refinance such debt. The terms of Hiland Partners’financing agreements may also prohibit it from taking such actions. Factorsthat will affect Hiland Partners’ ability to raise cash through an offering ofits common units or other equity, a refinancing of its debt or a sale of assetsinclude financial market conditions and Hiland Partners’ market value andoperating performance at the time of such offering or other financing. Wecannot assure that any such proposed offering, refinancing or sale of assetscan be successfully completed or, if completed, that the terms will befavorable to Hiland Partners or to us.

 

***If the Hiland Partners Merger iscompleted and the Hiland Holdings Merger is not completed, it could createcertain conflicts of interest between us and Harold Hamm, who, with hisaffiliates, controls our general partner and the general partner of HilandPartners.***

 

Harold Hamm andhis affiliates own 100% of our general partner, which has sole responsibilityfor conducting our business and managing our operations.  We control the general partner of HilandPartners, which has sole responsibility for conducting the business of HilandPartners and managing its operations.

 

If the Hiland HoldingsMerger is not completed but the Hiland Partners Merger is completed, Mr. Hamm,his affiliates and the Hamm family trusts will acquire all of the outstandingcommon units of Hiland Partners not owned by us.  We own, directly or indirectly, a 2% generalpartner interest, the incentive distribution rights, 3,060,000 subordinatedunits and 2,321,471 common units in Hiland Partners.  Since the common units have different rightsto distributions than the subordinated units and the incentive distributionrights, Mr. Hamm’s ownership of common units of Hiland Partners couldincrease the likelihood that conflicts of interest may arise between Mr. Hammand his affiliates, including our general partner, on the one hand, and us andour unitholders, on the other hand, particularly with regard to the amount ofcash to be distributed to the Hiland Partners unitholders and the amount ofcash to be reserved for the future conduct of Hiland Partners’ business.

 

***Asubstantial portion of our partnership interests in Hiland Partners aresubordinated to Hiland Partners’ common units, which will result in decreaseddistributions to us in the future until Hiland Partners has paid all distributionarrearages on the Hiland Partners common units.   Additionally, if Hiland Partners is unableto meet its minimum quarterly distribution in the future, distributions to uscould further decrease.***

 

We own, directly or indirectly, 5,381,471 units representing limitedpartner interests in Hiland Partners, of which approximately 56.9% aresubordinated units and 43.1% are common units. During the subordination period,the subordinated units will not receive any distributions in a quarter untilHiland Partners has paid the minimum quarterly distribution of $0.45 per unit,plus any arrearages in the payment of the minimum quarterly distribution fromprior quarters, on all of the outstanding Hiland Partners common units.Distributions on the subordinated units are therefore more uncertain thandistributions on Hiland Partners’ common units. Furthermore, no distributionsmay be made on the incentive distribution rights for any quarter unless HilandPartners has paid that quarter’s minimum quarterly distribution of $0.45 perunit for all outstanding Hiland Partners common units and subordinated units,plus any arrearages in the payment of the minimum quarterly distribution fromprior quarters on all the outstanding Hiland Partners common units. Therefore,distributions with respect to the incentive distribution rights are even moreuncertain than distributions on 

 

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the subordinatedunits. Neither the subordinated units nor the incentive distribution rights areentitled to any arrearages from prior quarters. Generally, the subordinationperiod ends, and the subordinated units convert into common units of HilandPartners, only after March 31, 2010 and only upon the satisfaction ofcertain financial tests.

 

Hiland Partners has suspended quarterly cash distributions on itscommon and subordinated units beginning with the first quarter of 2009.  Under the terms of the Hiland Partnerspartnership agreement, the Hiland Partners common units now carry an arrearageof $0.90 per unit, representing the minimum quarterly distribution to theHiland Partners common units for the first and second quarter of 2009 that mustbe paid before Hiland Partners can make distributions to the Hiland Partnerssubordinated units or on the incentive distribution rights.  This decrease in distributions to us couldadversely affect our ability to pay distributions on our common units.

 

***If wefail to renegotiate our credit facility, we may be required to sell commonunits in Hiland Partners to satisfy our outstanding debt obligations and anycurrent liabilities that we may incur in the operation of our business in thefuture.***

 

Hiland Partnerssuspended quarterly cash distributions on common and subordinated unitsbeginning with the first quarter distribution of 2009.  As our only cash-generating assets are our 2%general partner interest, all of the incentive distribution rights and a 57.4%limited partner interest in Hiland Partners, our cash flow is completelydependent upon the ability of Hiland Partners to make cash distributions to itspartners, including us.  Our creditfacility matures on December 31, 2009, at which time all outstanding amountsthereunder will become due and payable. We cannot assure that any refinancing of our credit facility can besuccessfully completed or, if completed, that the terms will be favorable tous.  If we are unable to obtain arefinancing of our outstanding debt and Hiland Partners does not resume payingquarterly cash distributions in amounts necessary to satisfy our obligations,we may need to sell common units in Hiland Partners to satisfy our outstandingdebt obligations and any current liabilities that we may incur in the operationof our business in the future.  

 

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

 

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

 

None.

 

**Item 3.Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5.Other Information**

 

*NASDAQ Deficiency Letter*. On January 27, 2009, we received aDeficiency Letter from NASDAQ indicating that we no longer comply with theaudit committee composition requirements as set forth in Marketplace Rule 4350(d),which requires Hiland Partners GP Holdings, LLC, our general partner, to havean audit committee of at least three independent members.  Following the resignation of Shelby E. Odellfrom the board of directors of our general partner on January 21, 2009,the audit committee of our general partner consists of only two independentmembers.  Mr. Odell resigned fromthe board of directors of our general partner so that he would be eligible toserve as a member of the conflicts committee of the board of directors ofHiland Partners’ general partner.  Inaccordance with Marketplace Rule 4350(d)(4), NASDAQ has provided us a cureperiod to regain compliance until the earlier of our next annual unitholders’meeting or January 21, 2010.

 

*First Amended and Restated Credit Agreement*. Pursuant to the terms of our existing credit agreement, we elected toreduce the commitment level on the credit facility from $10.0 million to $3.0million on August 7, 2009.  Concurrentlywith the reduction of the commitment level to $3.0 million, the existinglenders under the credit facility assigned their interests in the facility toThe Security National Bank of Enid and we entered into a first amended andrestated senior secured credit agreement with The Security National Bank ofEnid.   The credit facility is secured byall of our ownership interests in Hiland Partners and its general partner,other than the 2% general partner interest and the incentive distributionrights. The credit facility willmature on December 31, 2009, at which time all outstanding amounts thereunderbecome due and payable.

 

Indebtedness under the credit facility bears interest at the prime rateplus 1% per annum, but in no event less than 5% per annum, to be adjusted aschanges occur in the prime rate.  AtAugust 7, 2009, the interest rate on outstanding borrowings from our creditfacility was 5.0%.

 

The credit facility contains several covenants that, among otherthings, require the maintenance of a debt-to-worth ratio and require financialreports to be submitted periodically.

 

The amount we may borrow under the credit facility is limited to thelesser of: (i) 50% of the sum of the value of the Hiland Partners commonand subordinated units and (ii) the maximum available amount of the creditfacility (currently $3.0 million). For purposes of this calculation, the value of (i) the Hiland Partnerscommon units on any date shall be the closing price for such units as reflectedon the NASDAQ National Market on any date and (ii) the Hiland Partnerssubordinated units on any date shall be deemed to equal 85% of the value of theHiland Partners common units on such date. At August 7, 2009, the borrowing base was $3.0 million.

 

The credit facility contains various covenants that limit, among otherthings, subject to certain exceptions, our ability to grant liens, enter intoagreements restricting our ability to grant liens on our assets or amend thecredit facility, make certain loans, acquisitions and investments or enter intoa merger, consolidation or sale of assets.

 

                        As of August 7, 2009, we had$2.5 million outstanding under this credit facility and were in compliancewith our debt-to-worth ratio covenant. The outstanding $1.2 million atJune 30, 2009, which matures on December 31, 2009, is included in accruedliabilities and other in the balance sheet.

 

**Item 6. Exhibits**

 

**EXHIBITS**

 
| **Exhibit Number** | ** ** | **Description** |
|-------------------------|------------|-----------------|
|                    |       |            |   |
| 1.1                     |       |            | Underwriting  Agreement by and between Hiland Holdings GP, LP and Lehman Brothers Inc., as  representative of the underwriters named therein dated as of  September 19, 2006. (incorporated by reference to Exhibit 1.1 of  Registrant’s Statement on Form S-1 (File No. 333-134491)) |
|                    |       |            |   |
| 2.1                     |       |            | Contribution  Agreement among Hiland Holdings GP, LP, Hiland Partners GP  Holdings, LLC, Hiland Partners GP, Inc., Continental Gas  Holdings, Inc., HHGP Holding, LLC, Harold Hamm DST Trust, Harold  Hamm HJ Trust, Randy Moeder, Equity Financial Services, Inc. and Ken  Maples dated May 24, 2006. (incorporated by reference to  Exhibit 2.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491)) |
|                    |       |            |   |
| 2.2                     |       |            | Acquisition  Agreement by and among Hiland Operating, LLC, Hiland Partners, LLC and the  members of Hiland Partners, LLC dated as of September 1, 2005 (incorporated  by reference to Exhibit 2.2 of Hiland Partners, LP’s Form 8-K filed  on September 29, 2005) |

 

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| 2.3    |   |   | Amendment  No. 1 dated September 12, 2006 to Contribution Agreement among  Hiland Holdings GP, LP, Hiland Partners GP Holdings, LLC, Hiland  Partners GP, Inc., Continental Gas Holdings, Inc., HHGP  Holding, LLC, Harold Hamm DST Trust, Harold Hamm HJ Trust, Randy Moeder,  Equity Financial Services, Inc. and Ken Maples dated May 24, 2006.  (incorporated by reference to Exhibit 2.3 of Registrant’s Statement on  Form S-1 (File No. 333-134491)) |
|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.4    |   |   | Agreement and Plan of  Merger, dated as of June 1, 2009, by and between Hiland Holdings GP, LP,  Hiland Partners GP Holdings, LLC, HH GP Holding, LLC and HPGP MergerCo, LLC  (incorporated by reference to Exhibit 2.1 of the Registrant’s  Form 8-K filed on June 1, 2009). Schedules and Exhibits are omitted  pursuant to Section 601(b)(2) of Regulation S-K.                                                                                                                        |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.5    |   |   | Equity  Commitment Letter Agreement, dated as of June 1, 2009, by and between  Harold Hamm and HH GP Holding, LLC (incorporated by reference to  Exhibit 2.3 of the Registrant’s Form 8-K filed on June 1,  2009).                                                                                                                                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.6    |   |   | Support  Agreement, dated as of June 1, 2009, by and between Hiland Holdings GP,  LP, Hiland Partners GP Holdings, LLC, Harold Hamm, Continental Gas  Holdings, Inc., Bert Mackie, as trustee of the Harold Hamm DST Trust and  the Harold Hamm HJ Trust, HH GP Holding, LLC and HPGP MergerCo, LLC  (incorporated by reference to Exhibit 2.5 of the Registrant’s  Form 8-K filed on June 1, 2009).                                                                                           |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.7    |   |   | Agreement and  Plan of Merger, dated as of June 1, 2009, by and between Hiland  Partners, LP, Hiland Partners GP, LLC, HH GP Holding, LLC and HLND MergerCo,  LLC (incorporated by reference to Exhibit 2.2 of the Registrant’s  Form 8-K filed on June 1, 2009).   Schedules and Exhibits are omitted pursuant to Section 601(b)(2) of  Regulation S-K.                                                                                                                             |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.8    |   |   | Equity  Commitment Letter Agreement, dated as of June 1, 2009, by and between  Harold Hamm and HH GP Holding, LLC (incorporated by reference to  Exhibit 2.4 of the Registrant’s Form 8-K filed on June 1,  2009).                                                                                                                                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 2.9    |   |   | Support  Agreement, dated as of June 1, 2009, by and between Hiland Partners, LP,  Hiland Partners GP, LLC, Hiland Holdings GP, LP, Hiland Partners GP Holdings,  LLC, HH GP Holding, LLC and HLND MergerCo, LLC (incorporated by reference to  Exhibit 2.6 of the Registrant’s Form 8-K filed on June 1, 2009).                                                                                                                                                                                    |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.1    |   |   | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.2    |   |   | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to  Exhibit 3.1 of Registrant’s Form 10-Q filed on November 13,  2006)                                                                                                                                                                                                                                                                                                                 |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.3    |   |   | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference  to  Exhibit 3.3 of Registrant’s  Statement on Form S-1 (File No. 333-134491))                                                                                                                                                                                                                                                                                                                             |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.4    |   |   | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006)                                                                                                                                                                                                                                                                                                      |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1    |   |   | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                                                                                                                                                                                                                                                                                                                   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.2    |   |   | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to  Exhibit 3.1 of Registrant’s Form 10-Q filed on November 13,  2006)                                                                                                                                                                                                                                                                                                                 |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.3    |   |   | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference  to  Exhibit 3.3 of Registrant’s  Statement on Form S-1 (File No. 333-134491))                                                                                                                                                                                                                                                                                                                             |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.4    |   |   | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006)                                                                                                                                                                                                                                                                                                      |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1   |   |   | First Amended  and Restated Senior Secured Credit Agreement                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 19.1   |   |   | Code of Ethics  for Chief Executive Officer and Senior Finance Officers (incorporated by  reference to Exhibit 19.1 of Registrant’s annual report on  Form 10-K filed on March 20, 2007)                                                                                                                                                                                                                                                                                                                 |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 21.1   |   |   | List of  Subsidiaries of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 21.1  of Registrant’s  Statement on Form S-1 (File No. 333-134491))                                                                                                                                                                                                                                                                                                                                          |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.1   | — |   | Certification of  Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

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| 31.2   | — |   | Certification of  Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of  2002 |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                |
| 32.1   | — |   | Certification of  Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of  2002 |
|   |   |   |                                                                                                |
| 32.2   | — |   | Certification of  Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of  2002 |

 

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

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

 

**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 August, 2009.

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

 

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**Exhibit Index**

 
| **Exhibit Number** | ** ** | **Description** |
|-------------------------|------------|-----------------|
| ** **              | ** ** | ** **      |
| 1.1                     |       |            | Underwriting  Agreement by and between Hiland Holdings GP, LP and Lehman Brothers Inc., as  representative of the underwriters named therein dated as of  September 19, 2006. (incorporated by reference to Exhibit 1.1 of  Registrant’s Statement on Form S-1 (File No. 333-134491)) |
|                    |       |            |   |
| 2.1                     |       |            | Contribution  Agreement among Hiland Holdings GP, LP, Hiland Partners GP Holdings, LLC,  Hiland Partners GP, Inc., Continental Gas Holdings, Inc., HHGP  Holding, LLC, Harold Hamm DST Trust, Harold Hamm HJ Trust, Randy Moeder,  Equity Financial Services, Inc. and Ken Maples dated May 24, 2006.  (incorporated by reference to Exhibit 2.1 of Registrant’s Statement on  Form S-1 (File No. 333-134491)) |
|                    |       |            |   |
| 2.2                     |       |            | Acquisition  Agreement by and among Hiland Operating, LLC, Hiland Partners, LLC and the  members of Hiland Partners, LLC dated as of September 1, 2005  (incorporated by reference to Exhibit 2.2 of Hiland Partners, LP’s  Form 8-K filed on September 29, 2005) |
|                    |       |            |   |
| 2.3                     |       |            | Amendment  No. 1 dated September 12, 2006 to Contribution Agreement among  Hiland Holdings GP, LP, Hiland Partners GP Holdings, LLC, Hiland  Partners GP, Inc., Continental Gas Holdings, Inc., HHGP  Holding, LLC, Harold Hamm DST Trust, Harold Hamm HJ Trust, Randy Moeder,  Equity Financial Services, Inc. and Ken Maples dated May 24, 2006.  (incorporated by reference to Exhibit 2.3 of Registrant’s Statement on  Form S-1 (File No. 333-134491)) |
|                    |       |            |   |
| 2.4                     |       |            | Agreement and Plan of  Merger, dated as of June 1, 2009, by and between Hiland Holdings GP, LP,  Hiland Partners GP Holdings, LLC, HH GP Holding, LLC and HPGP MergerCo, LLC  (incorporated by reference to Exhibit 2.1 of the Registrant’s Form 8-K  filed on June 1, 2009). Schedules and Exhibits are omitted pursuant to  Section 601(b)(2) of Regulation S-K. |
|                    |       |            |   |
| 2.5                     |       |            | Equity  Commitment Letter Agreement, dated as of June 1, 2009, by and between  Harold Hamm and HH GP Holding, LLC (incorporated by reference to  Exhibit 2.3 of the Registrant’s Form 8-K filed on June 1,  2009). |
|                    |       |            |   |
| 2.6                     |       |            | Support  Agreement, dated as of June 1, 2009, by and between Hiland Holdings GP,  LP, Hiland Partners GP Holdings, LLC, Harold Hamm, Continental Gas  Holdings, Inc., Bert Mackie, as trustee of the Harold Hamm DST Trust and  the Harold Hamm HJ Trust, HH GP Holding, LLC and HPGP MergerCo, LLC  (incorporated by reference to Exhibit 2.5 of the Registrant’s  Form 8-K filed on June 1, 2009). |
|                    |       |            |   |
| 2.7                     |       |            | Agreement and Plan of  Merger, dated as of June 1, 2009, by and between Hiland Partners, LP,  Hiland Partners GP, LLC, HH GP Holding, LLC and HLND MergerCo, LLC  (incorporated by reference to Exhibit 2.2 of the Registrant’s  Form 8-K filed on June 1, 2009). Schedules and Exhibits are omitted  pursuant to Section 601(b)(2) of Regulation S-K. |
|                    |       |            |   |
| 2.8                     |       |            | Equity  Commitment Letter Agreement, dated as of June 1, 2009, by and between  Harold Hamm and HH GP Holding, LLC (incorporated by reference to  Exhibit 2.4 of the Registrant’s Form 8-K filed on June 1,  2009). |
|                    |       |            |   |
| 2.9                     |       |            | Support  Agreement, dated as of June 1, 2009, by and between Hiland Partners, LP,  Hiland Partners GP, LLC, Hiland Holdings GP, LP, Hiland Partners GP Holdings,  LLC, HH GP Holding, LLC and HLND MergerCo, LLC (incorporated by reference to  Exhibit 2.6 of the Registrant’s Form 8-K filed on June 1,  2009). |
|                    |       |            |   |
| 3.1                     |       |            | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491)) |
|                    |       |            |   |
| 3.2                     |       |            | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.1 of Registrant’s Form 10-Q  filed on November 13, 2006) |
|                    |       |            |   |
| 3.3                     |       |            | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on Form S-1 (File  No. 333-134491)) |
|                    |       |            |   |
| 3.4                     |       |            | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of Registrant’s  Form 10-Q filed on November 13, 2006) |

 

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| 4.1    |   |   | Certificate of  Limited Partnership of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 3.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                              |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                    |
| 4.2    |   |   | Amended and  Restated Agreement of Limited Partnership of Hiland Holdings GP, LP  (incorporated by reference to Exhibit 3.1 of Registrant’s Form 10-Q  filed on November 13, 2006)                  |
|   |   |   |                                                                                                                                                                                                                    |
| 4.3    |   |   | Certificate of  Formation of Hiland Partners GP Holdings, LLC (incorporated by reference to  Exhibit 3.3 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                              |
|   |   |   |                                                                                                                                                                                                                    |
| 4.4    |   |   | Amended and  Restated Limited Liability Company Agreement of Hiland Partners GP  Holdings, LLC(incorporated by reference to Exhibit 3.2 of  Registrant’s Form 10-Q filed on November 13, 2006) |
|   |   |   |                                                                                                                                                                                                                    |
| 10.1   |   |   | First Amended  and Restated Senior Secured Credit Agreement                                                                                                                                                             |
|   |   |   |                                                                                                                                                                                                                    |
| 19.1   |   |   | Code of Ethics  for Chief Executive Officer and Senior Finance Officers (incorporated by  reference to Exhibit 19.1 of Registrant’s annual report on  Form 10-K filed on March 20, 2007)            |
|   |   |   |                                                                                                                                                                                                                    |
| 21.1   |   |   | List of  Subsidiaries of Hiland Holdings GP, LP (incorporated by reference to  Exhibit 21.1 of Registrant’s Statement on Form S-1 (File  No. 333-134491))                                           |
|   |   |   |                                                                                                                                                                                                                    |
| 31.1   | — |   | Certification of  Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                     |
|   |   |   |                                                                                                                                                                                                                    |
| 31.2   | — |   | Certification of  Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                     |
|   |   |   |                                                                                                                                                                                                                    |
| 32.1   | — |   | Certification of  Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                     |
|   |   |   |                                                                                                                                                                                                                    |
| 32.2   | — |   | Certification of  Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                     |

 

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

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

 

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