Document:

AMENDMENT
NO. 4

This AMENDMENT NO. 4 (“Agreement”) entered into and made effective as
of June 30, 2006 (“Effective Date”) is among Cano Petroleum, Inc., a
Delaware corporation (“Borrower”), the Guarantors (as defined below), the
Lenders (as defined below), and Union Bank of California, N.A., as
administrative agent for such Lenders (in such capacity, the “Administrative
Agent”) and as issuing lender (in such capacity, the “Issuing Lender”).

RECITALS

A.            The Borrower is party to that
certain Credit Agreement dated as of November 29, 2005, as amended by the
Amendment No. 1 dated as of February 24, 2006, and as amended by the
Amendment No. 2, Assignment and Agreement dated as of April 28, 2006,
and Amendment No. 3 entered into on May 12, 2006 but made effective as
of March 31, 2006 (as so amended, the “Credit Agreement”) among the
Borrower, the lenders party thereto from time to time (the “Lenders”), the
Administrative Agent, and the Issuing Lender.

B.            The Borrower, the Lenders and the
Administrative Agent wish to, subject to the terms and conditions of this
Agreement make certain amendments to the Credit Agreement as provided herein.

THEREFORE,
the Borrower, the Guarantors, the Lenders, and the Administrative Agent hereby
agree as follows:

Section 1.              Defined
Terms. As used in
this Agreement, each of the terms defined in the opening paragraph and the
Recitals above shall have the meanings assigned to such terms therein. Each
term defined in the Credit Agreement and used herein without definition shall
have the meaning assigned to such term in the Credit Agreement, unless
expressly provided to the contrary.

Section 2.              Other
Definitional Provisions. Article, Section, Schedule, and Exhibit references are to Articles
and Sections of and Schedules and Exhibits to this Agreement, unless otherwise
specified. All references to instruments, documents, contracts, and agreements
are references to such instruments, documents, contracts, and agreements as the
same may be amended, supplemented, and otherwise modified from time to time,
unless otherwise specified. The words “hereof”, “herein”, and “hereunder” and
words of similar import when used in this Agreement shall refer to this
Agreement as a whole and not to any particular provision of this Agreement. The
term “including” means “including, without limitation,”. Paragraph headings
have been inserted in this Agreement as a matter of convenience for reference
only and it is agreed that such paragraph headings are not a part of this
Agreement and shall not be used in the interpretation of any provision of this
Agreement.

Section 3.              Amendments to Credit
Agreement.

(a)           Section 1.01 of
the Credit Agreement is amended by replacing the definitions of “Maturity Date”
and “Interest Expense” in their entirety with the following corresponding
terms:

 

“Maturity Date”
means November 28, 2008.

“Interest Expense” means,
for the Borrower and its consolidated Subsidiaries for any period, total
interest, letter of credit fees, and other fees and expenses incurred in
connection with any Debt for such period, whether paid or accrued, including,
without limitation, all interests, dividends, distributions or other payments
made in respect of preferred Equity Interests or Debt Issuances, and all
commissions, discounts and other fees and charges owed with respect to letters
of credit and bankers’ acceptance financing, imputed interest under Capital
Leases, and net costs under Interest Hedge Agreements, all as determined in
conformity with GAAP.

(b)           Section 1.01 of
the Credit Agreement is further amended by inserting the following new
definitions in alphabetical order:

“Debt Issuance” means the issuance by the Borrower of Debt in
the form of convertible notes.

“Debt Issuance Proceeds” means, with respect to any Debt
Issuance, all cash and cash equivalent investments received by the Borrower
from such Debt Issuance after payment of, or provision for, all underwriter
fees and expenses, SEC and blue sky fees, printing costs, fees and expenses of
accountants, lawyers and other professional advisors, brokerage commissions and
other out-of-pocket fees and expenses actually incurred in connection with such
Debt Issuance.

“Equity Issuance” means any issuance of equity securities or any
other Equity Interests (including any preferred equity securities) by the
Borrower or any of its Subsidiaries other than equity securities issued (i) to
the Borrower or one of its Subsidiaries, (ii) pursuant to employee or
director and officer stock option plans in the ordinary course of business, and
(iii) the conversion of previously issued preferred, convertible Equity
Interests or convertible notes to the extent such Equity Interests and notes
were issued in compliance with the terms hereof.

“Equity Issuance Proceeds” means, with respect to any Equity
Issuance, all cash and cash equivalent investments received by the Borrower or
any of its Subsidiaries from such Equity Issuance after payment of, or
provision for, all underwriter fees and expenses, SEC and blue sky fees,
printing costs, fees and expenses of accountants, lawyers and other
professional advisors, brokerage commissions and other out-of-pocket fees and
expenses actually incurred in connection with such Equity Issuance.

“General Corporate Advance Amount” means, as of the date of
determination, the aggregate amount of Advances outstanding on such date and
the proceeds of which were applied by the Borrower or any of its Subsidiaries
for general corporate purposes or working capital purposes.

“Junior Capital Issuance” means either (a) an Equity
Issuance permitted under Section 6.22 or (b) a Debt Issuance.

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“Leverage Ratio” means, as of the end of any fiscal quarter, the
ratio of (a) the consolidated Debt of the Borrower as of such fiscal
quarter end to (b) the consolidated EBITDA of the Borrower for the four
fiscal quarter period then ended.

“Liquidity Deposit Amount” means, at the time determination, the
aggregate amount of Equity Issuance Proceeds and Debt Issuance Proceeds which
have been deposited into a deposit account with the Administrative Agent or any
Lender or any other depository bank that has executed an account control
agreement reasonably acceptable in form and substance to the Administrative
Agent, as required under Section 5.13, regardless of whether such proceeds
are, at such time, held in such deposit account.

(c)           The first sentence of Section 2.01(a) of
the Credit Agreement is deleted in its entirety and replaced with the
following:

Each Lender severally agrees, on the terms and conditions set forth in
this Agreement, to make Advances to the Borrower from time to time on any
Business Day during the period from the date of this Agreement until the
Commitment Termination Date in an amount for each Lender not to exceed such
Lender’s Unused Commitment Amount; provided that, no Lender shall have an
obligation to make Advances if the making of such Advances would cause the
General Corporate Advance Amount to exceed $10,000,000.

(d)           The last sentence of
Section 2.02(a) of the Credit Agreement is deleted in its entirety
and replaced with the following:

The Borrowing Base shall be
determined in accordance with the standards set forth in Section 2.02(d) and
is subject to periodic redetermination pursuant to Sections 2.02(b), 2.02(c) and
2.02(e).

(e)           Section 2.02 of
the Credit Agreement is hereby amended by replacing clause (e) thereof in
its entirety with the following:

(e)           In addition to the Borrowing Base redeterminations
provided for in Section 2.02(b) and Section 2.02(c), the
Administrative Agent and the Lenders may (i) in their sole discretion and
based on such information as the Administrative Agent and the Lenders deem
relevant (but in accordance with Section 2.02(d)), redetermine the
Borrowing Base upon a Junior Capital Issuance by the Borrower and (ii) in
their sole discretion and based on such information as the Administrative Agent
and the Lenders deem relevant (but in accordance with Section 2.02(d)),
redetermine the Borrowing Base if a Junior Capital Issuance by the Borrower has
not occurred on or prior to August 30, 2006. The parties hereto
acknowledge and agree that should such interim redetermination occur pursuant
to this clause (e), the Lenders may, but are not obligated to, waive the
scheduled redetermination of the Borrowing Base which is scheduled to occur
pursuant to Section 2.02(b)(i) on September 30, 2006.

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(f)            Section 2.05
of the Credit Agreement is hereby amended by replacing clause (f) thereof
in its entirety with the following:

(f)            Debt Issuance. If the Borrower or any Subsidiary
of the Borrower receives Debt Issuance Proceeds, then immediately upon receipt
of such proceeds, the Borrower shall prepay the Advances or, if the Advances
have been repaid in full, make deposits into the Cash Collateral Account to
provide cash collateral for the Letter of Credit Exposure, in an amount equal
to (A) 100% of such Debt Issuance Proceeds minus (B) the
amount applied to satisfy outstanding Subordinated Debt minus (C) the
amount, if any, necessary to cause the Liquidity Deposit Amount at the time of
such Debt Issuance to equal $2,500,000. The prepayment required pursuant to
this Section 2.05(f) shall be accompanied by accrued interest on the
amount prepaid to the date of such prepayment and amounts, if any, required to
be paid pursuant to Section 2.12 as a result of such prepayment being made
on such date. Such prepayment shall be applied to the Advances as determined by
the Administrative Agent and agreed to by the Lenders in their sole discretion.

(g)           Section 2.05 of
the Credit Agreement is hereby further amended by adding the following new
clause (g) to the end thereof

(g)          Equity Issuance. If the Borrower or any Subsidiary
of the Borrower receives Equity Issuance Proceeds, then immediately upon
receipt of such proceeds, the Borrower shall prepay the Advances or, if the
Advances have been repaid in full, make deposits into the Cash Collateral
Account to provide cash collateral for the Letter of Credit Exposure, in an
amount equal to (A) 100% of such Equity Issuance Proceeds minus (B) the
amount applied to satisfy outstanding Subordinated Debt minus (C) the
amount, if any, necessary to cause the Liquidity Deposit Amount at the time of
such Equity Issuance to equal $2,500,000. The prepayment required pursuant to
this Section 2.05(g) shall be accompanied by accrued interest on the
amount prepaid to the date of such prepayment and amounts, if any, required to
be paid pursuant to Section 2.12 as a result of such prepayment being made
on such date. Such prepayment shall be applied to the Advances as determined by
the Administrative Agent and agreed to by the Lenders in their sole discretion.

(h)           Section 5.06(b) of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

(b)          Monthly Financials. As soon as available and in any
event not later than 45 days after the end of each calendar month, commencing with
June 30, 2006, (i) the unaudited balance sheet and the statements of
income, cash flows, and retained earnings of each such Person for the period
commencing at the end of the previous year and ending with the end of such
calendar month, all in reasonable detail and duly certified with respect to
such consolidated statements (subject to year-end audit adjustments) by a
Responsible Officer of the Borrower as having been prepared in accordance with
GAAP, (ii) for each calendar month 

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end that is also a fiscal quarter
end (and that is not a fiscal year end), the Form 10-QSB filed with
the SEC for such fiscal quarter end, and (iii) a Compliance Certificate
executed by the Responsible Officer of the Borrower;

(i)            Section 5.06(d) of
the Credit Agreement is deleted in its entirety and replaced with the
following:

(d)          Production and Hedging Reports. As soon as available
and in any event within 45 days after the end of each calendar month,
commencing with June 30, 2006, a report certified by a Responsible Officer
of the Borrower in form and substance satisfactory to the Administrative Agent
prepared by the Borrower (i) covering each of the Oil and Gas Properties
of the Borrower and its Subsidiaries (including the Barnett Shale Properties)
and detailing on a monthly basis (A) the production, revenue, and price
information and associated operating expenses for each such month, (B) any
changes to any producing reservoir, production equipment, or producing well
during each such month, which changes could cause a Material Adverse Change,
and (C) any sales of the Borrower’s or any Subsidiaries’ Oil and Gas
Properties during each such month, (ii) setting forth a true and complete
list of all Hedge Contracts of the Borrower and its Subsidiaries and detailing
the material terms thereof (including the type, term, effective date,
termination date and notional amounts or volumes), the net mark to market value
thereof, all credit support agreements relating thereto (including any margin
required or supplied), and the counterparty to each such agreement, and (iii) certifying
the Borrower’s compliance with Section 5.12 hereof.

(j)            Section 5.09
of the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 5.09         Use of Proceeds. The Borrower
shall use the proceeds of the Advances and Letters of Credit (a) to
develop Oil and Gas Properties, (b) for working capital purposes and (c) for
general corporate purposes; provided that (i) the Borrower shall not use
the proceeds of any Advance for any capital expenditure unless such capital
expenditure (as determined in accordance with GAAP) is approved in writing by
the Lenders prior to the application of such proceeds to fund such capital
expenditure; and (ii) the Borrower shall not use the proceeds of any Advance
for general corporate purposes or working capital purposes unless the use
thereof for such purposes would not cause the General Corporate Advance Amount,
after the application thereof, to exceed $10,000,000.

(k)           Section 5.12 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 5.12         Hedging Arrangements. The
Borrower shall:

(a) maintain the Hydrocarbon
Hedge Agreements in existence on March 31, 2006 and as described in
Schedule 5.12 (or such other floors or swaps as the required by the Required
Lenders) for a minimum period of at least three years as of the 

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end of December 31, 2006 and
as of the end of each six month period ending thereafter,

(b) on or before 10 days
following the effective date of Amendment No. 2, cause Pantwist, LLC to
enter into, and from and after such date, maintain (i) Hydrocarbon Hedge
Agreements covering not less than 50% of the “proved, developed and producing”
crude oil reserves attributable to the Twister Oil and Gas Properties for a
minimum period of at least three years as of the effective date of Amendment No. 2
and as of the end of each two fiscal quarter period ending thereafter, and at a
minimum floor of $60 per Bbl (or such other minimum floor as required by the
Required Lenders from time to time), and (ii) Hydrocarbon Hedge Agreements
covering not less than 50% of the “proved, developed and producing” natural gas
reserves attributable to the Twister Oil and Gas Properties for a minimum
period of at least three years as of the effective date of Amendment No. 2
and as of the end of each two fiscal quarter period ending thereafter, and with
a weighted average contract price of $7.60 per Mcf (or such other weighted
average contract price as required by the Required Lenders from time to time),
and

(c) notwithstanding any of
the foregoing, maintain Hydrocarbon Hedge Agreements covering no less than 50%
and no more than 80% of the production volumes attributable to “proved,
developed and producing” Proven Reserves of the Borrower’s and its Subsidiaries’
Oil and Gas Properties.

(l)            Section 6.02
of the Credit Agreement is hereby amended by (i) replacing the period
appearing at the end of clause (i) thereof with a semicolon and (ii) adding
new clauses (j) and (k) to the end thereof as follows:

(j)            Debt Issuance
by the Borrower; provided that (i) such issuance, together with any Equity
Issuance of convertible, preferred stock in accordance with Section 6.22,
shall not exceed $60,000,000 in the aggregate; (ii) such Debt shall have (A) a
maturity date that is no earlier than November 28, 2009, (B) covenants
and restrictions that are no more restrictive than those set forth in this
Agreement and the other Loan Documents and which are, in any event,
satisfactory to the Administrative Agent, (C) no restriction on the
ability of the Borrower or any of its Subsidiaries to amend, modify or
otherwise supplement this Agreement or the other Loan Documents, (D) no
collateral or other security for such Debt, (E) no restriction on the
ability of the Borrower or any of its Subsidiaries to guarantee the Obligations
or pledge assets as collateral security for the Obligations, (F) a bullet
repayment and not provide for amortization (other than amortization resulting
from any mandatory prepayments required in respect of such Debt in connection
with the occurrence of an event of default under such Debt), (G) conversion
terms acceptable to the Administrative Agent, and (H) such other terms,
conditions and provisions that are satisfactory to the Administrative Agent; (iii) such
Debt shall be subordinated, in right of payment and otherwise, to the payment
of the Obligations and the rights and remedies available to the Administrative
Agent, the Lenders and the Swap Counterparties 

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hereunder or under any other Loan Document, in a manner, and pursuant
to documentation, satisfactory to the Administrative Agent in its sole
discretion, including without limitation, payment blockage provisions and
standstill periods of no less than 180 days; (iv) the Debt Issuance
Proceeds shall be applied, first to satisfy the outstanding Subordinated Debt
in full and second to prepay the Obligations as calculated under Section 2.05(f);
and (v) such Debt Issuance shall not otherwise cause the occurrence of a
Default or Event of Default after giving effect to the issuance of such Debt;
and

(k)          Debt consisting of
preferred Equity Interests of the Borrower; provided that such Equity Interests
are issued in compliance with Section 6.22.

(m)          Section 6.05 of the Credit Agreement is deleted in its entirety
and replaced with the following:

Section 6.05         Restricted Payments. The
Borrower shall not, nor shall it permit any of its Subsidiaries to, make any
Restricted Payments except that if no Default has occurred both before and
after giving effect to the making of such Restricted Payment, (a) the
Subsidiaries may make Restricted Payments to the Borrower, (b) the
Borrower may make Restricted Payments to officers, directors, consultants and
employees of the Borrower or any Guarantor in any form other than cash or other
assets of the Borrower, (c) the Borrower may make Restricted Payments to
officers, directors, consultants and employees of the Borrower or any Guarantor
in the form of cash in an aggregate amount not to exceed $1,000,000 per fiscal
year, (d) the Borrower may make Restricted Payments in respect of
preferred Equity Interests which were issued in compliance with Section 6.22,
and (e) the Borrower may make Restricted Payments in respect of Debt
Issuances which were issued in compliance with Section 6.02(j) to the
extent such payments would be permitted under the subordination terms in effect
in favor of the Obligations and covering such Debt Issuances.

(n)           Section 6.18 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.18         Leverage Ratio.

(a)          Other than as provided in clause (b) below,
the Borrower shall not permit the Leverage Ratio at the end of each fiscal
quarter ending on or after March 31, 2007 to be greater than 5.00 to 1.00;
provided that, if the Subordinated Debt has been paid in full, then solely for
purposes of calculating Leverage Ratio under this clause (a), “consolidated
Debt” shall not include Debt outstanding under preferred Equity Interests
issued in compliance with Section 6.22.

(b)          If a Debt Issuance has occurred and
the Subordinated Debt has been paid in full, then the Borrower shall not permit
(i) the Leverage Ratio at the end of the fiscal quarter ending on March 31,
2007 to be greater than 7.50 to 1.00, (ii) the Leverage Ratio at the end
of the fiscal quarter ending June 30, 2007 to be greater than 7.00 to 1.00
and (iii) the Leverage Ratio at the end of each 

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fiscal quarter ending on or after
September 30, 2007 to be greater than 5.00 to 1.00; provided that, solely
for purposes of calculating Leverage Ratio under this clause (b), “consolidated
Debt” shall not include Debt outstanding under preferred Equity Interests, if
any, issued in compliance with Section 6.22.

(o)           Section 6.19 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.19         Interest Coverage Ratio. The
Borrower (a) shall not permit the ratio of, as of the fiscal quarter
ending June 30, 2006, (i) the consolidated EBITDA of the Borrower for
the fiscal quarter period then ended multiplied by four, to (ii) the
consolidated Interest Expense of the Borrower for the fiscal quarter period
then ended multiplied by four, to be less than 1.25 to 1.00; (b) shall not
permit the ratio of, as of the fiscal quarter ending September 30, 2006, (i) the
consolidated EBITDA of the Borrower for the two fiscal quarter period then
ended multiplied by two, to (ii) the consolidated Interest Expense of the
Borrower for the two fiscal quarter period then ended multiplied by two, to be
less than 1.25 to 1.00; (c) shall not permit the ratio of, as of the
fiscal quarter ending December 31, 2006, (i) the consolidated EBITDA
of the Borrower for the three fiscal quarter period then ended multiplied by
4/3, to (ii) the consolidated Interest Expense of the Borrower for the
three fiscal quarter period then ended multiplied by 4/3, to be less than 1.25
to 1.00; (d) shall not permit the ratio of, as of the fiscal quarter
ending March 31, 2007, (i) the consolidated EBITDA of the Borrower
calculated for the four fiscal quarters then ended, to (ii) the
consolidated Interest Expense of the Borrower for the four fiscal quarters then
ended, to be less than 1.50 to 1.00; and (e) shall not permit the ratio
of, as of the end of any fiscal quarter ending on or after June 30, 2007, (i) the
consolidated EBITDA of the Borrower calculated for the four fiscal quarters
then ended, to (ii) the consolidated Interest Expense of the Borrower for
the four fiscal quarters then ended, to be less than 2.00 to 1.00.

(p)           Article VI to
the Credit Agreement is hereby amended by adding a new Section 6.22 to the
end thereof as follows:

Section 6.22         Equity Issuance. The Borrower
shall not, nor shall it permit any of its Subsidiaries to, issue any preferred,
convertible equity securities or other Equity Interests unless (a) the
maturity thereof shall not be earlier than November 28, 2009, (b) the
other terms thereof, including any conversion terms, are satisfactory to the
Administrative Agent, (c) the Equity Issuance Proceeds thereof are
applied, first to satisfy the outstanding Subordinated Debt in full and second
to prepay the Obligations as calculated under Section 2.05(g), and (d) such
issuance of preferred or convertible Equity Interests, together with any Debt
Issuance permitted under Section 6.02(j), does not exceed $60,000,000 in
the aggregate.

(q)           Section 7.01 of
the Credit Agreement is hereby amended by replacing clause (c)(i) in its
entirety with the following:

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(i) perform or observe any
covenant contained in Section 5.02(a), Section 5.03, Section 5.06(e),
Section 5.09, Section 5.12, or Article VI of this Agreement or

(r)            Section 7.01
of the Credit Agreement is hereby further amended by adding a new clause (r) to
the end thereof as follows:

(r)           The first Debt Issuance, Equity Issuance or a series of
related transactions including both Debt Issuances and Equity Issuances
completed after June 30, 2006 results in aggregate Debt Issuance Proceeds
and/or Equity Issuance Proceeds of less than $45,000,000 or less than such
lesser amount as may be approved in writing by the Lenders; provided that, if
such lesser amount is approved by the Lenders, then the sum of such lesser
amount plus the aggregate Debt Issuance Proceeds and/or Equity Issuance
Proceeds from the second such transaction to be completed after June 30, 2006
is less than $45,000,000.

(s)           Schedule I-Pricing Grid, Schedule 4.07, Exhibit B —
Compliance Certificate, and Exhibit F- Notice of Borrowing which are
attached to the Credit Agreement are hereby replaced in their entirety with the
corresponding Schedule I-Pricing
Grid, Schedule 4.07, Exhibit B — Compliance Certificate, and Exhibit F-
Notice of Borrowing attached to this Agreement.

Section 4.              Consent
to Amendment Terms of the Subordinated Debt. As required under Section 6.20 of the
Credit Agreement, the Lenders hereby consent to the terms of the Third
Amendment to Subordinated Credit Agreement dated as of June 30, 2006, an
execution version of which is attached hereto as Exhibit A.

Section 5.              Borrower Representations and
Warranties.
The Borrower represents and
warrants that: (a) after giving effect to this Agreement, the
representations and warranties contained in the Credit Agreement and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of
such earlier date; (b) after giving effect to this Agreement, no Default
has occurred and is continuing; (c) the
execution, delivery and performance of this Agreement are within the corporate
power and authority of the Borrower and have been duly authorized by
appropriate corporate and governing action and proceedings; (d) this
Agreement constitutes the legal, valid, and binding obligation of the Borrower
enforceable in accordance with its terms, except as limited by applicable
bankruptcy, insolvency, reorganization, moratorium, or similar laws affecting
the rights of creditors generally and general principles of equity; (e) there
are no governmental or other third party consents, licenses and approvals
required in connection with the execution, delivery, performance, validity and
enforceability of this Agreement; and (f) the Liens under the Security
Instruments are valid and subsisting and secure Borrower’s obligations under
the Loan Documents.

Section 6.              Guarantors Representations
and Warranties. Each
Guarantor represents and warrants that: (a) after giving effect to this
Agreement, the representations and warranties contained in the Guaranty and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of
such earlier date; (b) after giving effect to this Agreement, no Default
has occurred and is continuing; (c) the execution, delivery and 

 9
 

 

performance of this
Agreement are within the corporate, limited liability company, or partnership
power and authority of such Guarantor and have been duly authorized by
appropriate corporate, limited liability company, or partnership action and
proceedings; (d) this Agreement constitutes the legal, valid, and binding
obligation of such Guarantor enforceable in accordance with its terms, except
as limited by applicable bankruptcy, insolvency, reorganization, moratorium, or
similar laws affecting the rights of creditors generally and general principles
of equity; (e) there are no governmental or other third party consents,
licenses and approvals required in connection with the execution, delivery,
performance, validity and enforceability of this Agreement; (f) it has no
defenses to the enforcement of the Guaranty; and (g) the Liens under the
Security Instruments are valid and subsisting and secure such Guarantor’s and
the Borrower’s obligations under the Loan Documents.

Section 7.              Conditions to Effectiveness. This Agreement and the amendments to the
Credit Agreement provided herein shall become effective on the Effective Date
and enforceable against the parties hereto upon the occurrence of the following
conditions precedent:

(a)           The Administrative Agent shall have
received multiple original counterparts, as requested by the Administrative
Agent, of this Agreement duly and validly executed and delivered by duly
authorized officers of the Borrower, the Guarantors, the Administrative Agent,
and the Lenders.

(b)           The representations
and warranties in this Agreement shall be true and correct in all material
respects.

(c)           The Borrower shall have paid (i) all fees and expenses of the Administrative
Agent’s outside legal counsel and other consultants pursuant to all invoices
presented for payment on or prior to the Effective Date, and (ii) an
amendment fee of $200,000 to the Administrative Agent for the account of the
Lenders.

Section 8.              Acknowledgments and
Agreements.

(a)           The Borrower acknowledges that on the
date hereof all Obligations are payable without defense, offset, counterclaim
or recoupment.

(b)           The Administrative
Agent and the Lenders hereby expressly reserve all of their rights, remedies,
and claims under the Loan Documents. Nothing in this Agreement shall constitute
a waiver or relinquishment of (i) any Default or Event of Default under
any of the Loan Documents, (ii) any of the agreements, terms or conditions
contained in any of the Loan Documents, (iii) any rights or remedies of
the Administrative Agent or any Lender with respect to the Loan Documents, or (iv) the
rights of the Administrative Agent or any Lender to collect the full amounts
owing to them under the Loan Documents.

(c)           Each of the
Borrower, the Guarantors, Administrative Agent, and Lenders does hereby adopt,
ratify, and confirm the Credit Agreement, as amended hereby, and acknowledges
and agrees that the Credit Agreement, as amended hereby, is and remains in full
force and effect, and the Borrower and the Guarantors acknowledge and agree
that their respective liabilities and obligations under the Credit Agreement,
as amended hereby, and the Guaranty, are not impaired in any respect by this
Agreement.

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(d)           From and after the
Effective Date, all references to the Credit Agreement and the Loan Documents
shall mean such Credit Agreement and such Loan Documents as amended by this
Agreement.

(e)           This Agreement is a
Loan Document for the purposes of the provisions of the other Loan Documents. Without
limiting the foregoing, any breach of representations, warranties, and
covenants under this Agreement shall be a Default or Event of Default, as
applicable, under the Credit Agreement.

Section 9.              Reaffirmation of the
Guaranty. Each Guarantor
hereby ratifies, confirms, acknowledges and agrees that its obligations under
the Guaranty are in full force and effect and that such Guarantor continues to
unconditionally and irrevocably guarantee the full and punctual payment, when
due, whether at stated maturity or earlier by acceleration or otherwise, all of
the Guaranteed Obligations (as defined in the Guaranty), as such Guaranteed
Obligations may have been amended by this Agreement, and its execution and
delivery of this Agreement does not indicate or establish an approval or
consent requirement by such Guarantor under the Guaranty in connection with the
execution and delivery of amendments, consents or waivers to the Credit
Agreement, the Notes or any of the other Loan Documents.

Section 10.            Counterparts.
This Agreement may be
signed in any number of counterparts, each of which shall be an original and
all of which, taken together, constitute a single instrument. This Agreement
may be executed by facsimile signature and all such signatures shall be
effective as originals.

Section 11.            Successors
and Assigns. This
Agreement shall be binding upon and inure to the benefit of the parties hereto
and their respective successors and assigns permitted pursuant to the Credit
Agreement.

Section 12.            Invalidity.
In the event that any
one or more of the provisions contained in this Agreement shall for any reason
be held invalid, illegal or unenforceable in any respect, such invalidity,
illegality or unenforceability shall not affect any other provision of this
Agreement.

Section 13.            Governing
Law. This
Agreement shall be deemed to be a contract made under and shall be governed by
and construed in accordance with the laws of the State of Texas.

Section 14.            Entire Agreement. THIS
AGREEMENT, THE CREDIT AGREEMENT AS AMENDED BY THIS AGREEMENT, THE NOTES, AND
THE OTHER LOAN DOCUMENTS CONSTITUTE THE ENTIRE UNDERSTANDING AMONG THE PARTIES
HERETO WITH RESPECT TO THE SUBJECT MATTER HEREOF AND SUPERSEDE ANY PRIOR
AGREEMENTS, WRITTEN OR ORAL, WITH RESPECT THERETO.

THERE
ARE NO UNWRITTEN ORAL AGREEMENTS AMONG THE PARTIES.

[SIGNATURES
BEGIN ON NEXT PAGE]

 

 11

 

EXECUTED effective
as of the date first above written.

	
  BORROWER:

  	
  CANO PETROLEUM, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ S. Jefffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  Chief Executive Officer

  

 

	
  GUARANTORS:

  	
  SQUARE ONE ENERGY, INC.

  
	
   

  	
  LADDER COMPANIES, INC.

  
	
   

  	
  W.O. ENERGY OF NEVADA, INC.

  
	
   

  	
  WO ENERGY, INC.

  
	
   

  	
  PANTWIST, LLC

  
	
   

  	
   

  	
   

  
	
   

  	
  Each by:

  	
  /s/ S. Jefffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. OPERATING COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ S. Jefffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. PRODUCTION COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ S. Jefffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
				

 

 

 

	
  ADMINISTRATIVE AGENT/

  ISSUING LENDER/LENDER:

  	
  UNION BANK OF CALIFORNIA, N.A.,

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ Kimberly Coil

  
	
   

  	
   

  	
  Kimberly Coil

  
	
   

  	
   

  	
  Vice President

  

 

 

 

	
  

  	
  NATEXIS BANQUES POPULAIRES

  
	
   

  	
  as a Lender

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ Donovan C. Broussard

  
	
   

  	
   

  	
  Donavan C. Broussard

  
	
   

  	
   

  	
  Vice President & Group Manager

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ Timothy L. Polvado

  
	
   

  	
   

  	
  Timothy L. Polvado

  
	
   

  	
   

  	
  Vice President & Group Manager

  

 

Exhibit A

THIRD
AMENDMENT TO SUBORDINATED CREDIT AGREEMENT

This THIRD AMENDMENT TO SUBORDINATED CREDIT AGREEMENT (“Amendment”)
entered into and made effective as of June 30, 2006 (“Effective Date”) is
among Cano Petroleum, Inc., a Delaware corporation (“Borrower”), the
Guarantors (as defined below), the Lenders (as defined below), and Energy
Components SPC EEP Energy Exploration and Production Segregated Portfolio, a
Cayman Islands company, as administrative agent for such Lenders (in such
capacity, the “Administrative Agent”).

RECITALS

C.            The Borrower is party to that
certain Subordinated Credit Agreement dated as of November 29, 2005, as
amended by the First Amendment to Subordinated Credit Agreement dated as of April 28,
2006 and the Second Amendment to Subordinated Credit Agreement entered into on May 12,
2006 but made effective as of March 31, 2006 (as so amended, the “Credit
Agreement”) among the Borrower, the lenders party thereto from time to time
(the “Lenders”), and the Administrative Agent.

D.            The Borrower, the Lenders and the
Administrative Agent wish to, subject to the terms and conditions of this
Amendment, make certain amendments to the Credit Agreement as provided herein.

THEREFORE,
the Borrower, the Guarantors, the Lenders, and the Administrative Agent hereby
agree as follows:

Section 15.            Defined
Terms. As used in
this Amendment, each of the terms defined in the opening paragraph and the
Recitals above shall have the meanings assigned to such terms therein. Each
term defined in the Credit Agreement and used herein without definition shall
have the meaning assigned to such term in the Credit Agreement, unless
expressly provided to the contrary.

Section 16.            Other
Definitional Provisions. Article, Section, Schedule, and Exhibit references are to Articles
and Sections of and Schedules and Exhibits to this Amendment, unless otherwise
specified. All references to instruments, documents, contracts, and agreements
are references to such instruments, documents, contracts, and agreements as the
same may be amended, supplemented, and otherwise modified from time to time,
unless otherwise specified. The words “hereof”, “herein”, and “hereunder” and
words of similar import when used in this Amendment shall refer to this
Amendment as a whole and not to any particular provision of this Amendment. The
term “including” means “including, without limitation,”. Paragraph headings
have been inserted in this Amendment as a matter of convenience for reference
only and it is agreed that such paragraph headings are not a part of this
Amendment and shall not be used in the interpretation of any provision of this
Amendment.

 

Section 17.            Amendments to Credit
Agreement.

(f)            Section 1.01
of the Credit Agreement is amended by replacing the definitions of “Applicable
Margin” and “Maturity Date” in their entirety with the following corresponding
terms:

“Applicable Margin” means,
with respect to any Advance, (a) during any time when an Event of Default
exists, 9.5% per annum, (b) during any time which the Leverage Ratio is
greater than 4.00 to 1.00, 8.0% per annum, provided that for each calendar
quarter beginning on October 1, 2006 for which the Leverage Coverage Ratio
is greater than 4.00 to 1.00, such 8.0% per annum rate shall increase by .25%
on the first day of such calendar quarter to a maximum of 9.5% per annum, and (c) at
any time other than as provided in (a) and (b) above, 6.5% per annum.

“Maturity Date” means the
earlier of (i) November 28, 2009, or (ii) one year after the “Maturity
Date” as defined in the Senior Credit Agreement.

(g)           Section 1.01 of
the Credit Agreement is further amended by inserting the following new
definitions in alphabetical order:

“Debt Issuance” means the issuance by the Borrower of Debt in
the form of convertible notes.

“Debt Issuance Proceeds” means, with respect to any Debt
Issuance, all cash and cash equivalent investments received by the Borrower
from such Debt Issuance after payment of, or provision for, all underwriter
fees and expenses, SEC and blue sky fees, printing costs, fees and expenses of
accountants, lawyers and other professional advisors, brokerage commissions and
other out-of-pocket fees and expenses actually incurred in connection with such
Debt Issuance.

“Equity Issuance” means any issuance of equity securities or any
other Equity Interests (including any preferred equity securities) by the
Borrower or any of its Subsidiaries other than equity securities issued (i) to
the Borrower or one of its Subsidiaries and (ii) pursuant to employee or
director and officer stock option plans in the ordinary course of business.

“Equity Issuance Proceeds” means, with respect to any Equity
Issuance, all cash and cash equivalent investments received by the Borrower or
any of its Subsidiaries from such Equity Issuance after payment of, or
provision for, all underwriter fees and expenses, SEC and blue sky fees,
printing costs, fees and expenses of accountants, lawyers and other
professional advisors, brokerage commissions and other out-of-pocket fees and
expenses actually incurred in connection with such Equity Issuance.

“Junior Capital Issuance” means either (a) an Equity
Issuance (b) a Debt Issuance.

“Leverage Ratio” means, as of the end of any fiscal quarter, the
ratio of (a) the consolidated Debt of the Borrower as of such fiscal
quarter end to (b) the 

 3
 

 

consolidated EBITDA of the Borrower for the four fiscal quarter period
then ended.

(h)           The first sentence
of Section 2.03 of the Credit Agreement is hereby amended by replacing it
in its entirety with the following:

Section 2.03         Prepayment of Advance. Borrower
may prepay all, but not less than all, of the outstanding Advance during the
first year following the Effective Date (or any subsequent year pursuant to a
Junior Capital Issuance), after giving by 10:00 a.m. (Dallas, Texas time)
at least three Business Days’ irrevocable prior written notice to the
Administrative Agent stating the proposed date of such prepayment. If any such
notice is given, the Borrower shall prepay the Advance in its entirety by
delivering to the Administrative Agent an amount equal to 101% of the amount of
the Advance, together with accrued interest to the date of such prepayment on
the principal amount prepaid and amounts, if any, required to be paid pursuant
to Section 2.09 as a result of such prepayment being made on such date.

(i)            Section 2.03
of the Credit Agreement is hereby further amended by adding the following new
clause (c) to the end thereof:

(c)           Junior Capital Issuance. If the Borrower or any
Subsidiary receives Debt Issuance Proceeds or Equity Issuance Proceeds, then
immediately upon receipt of such proceeds, the Borrower shall prepay the
Advance, along with accrued interest and such fees as set forth in the first
two sentences of Section 2.03 above, in its entirety.

(j)            Section 5.06(b) of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

(b)          Monthly Financials. As soon as available and in any
event not later than 45 days after the end of each calendar month, commencing
with June 30, 2006, (i) the unaudited balance sheet and the statements
of income, cash flows, and retained earnings of each such Person for the period
commencing at the end of the previous year and ending with the end of such
calendar month, all in reasonable detail and duly certified with respect to
such consolidated statements (subject to year-end audit adjustments) by a
Responsible Officer of the Borrower as having been prepared in accordance with
GAAP, (ii) for each calendar month end that is also a fiscal quarter end
(and that is not a fiscal year end), the Form 10-QSB filed with the
SEC for such fiscal quarter end, and (iii) a Compliance Certificate
executed by the Responsible Officer of the Borrower;

(k)           Section 5.06(d) of
the Credit Agreement is deleted in its entirety and replaced with the
following:

(d)          Production and Hedging Reports. As soon as available
and in any event within 45 days after the end of each calendar month,
commencing with June 30, 2006, a report certified by a Responsible Officer
of the Borrower in form and 

 4
 

 

substance satisfactory to the Administrative
Agent prepared by the Borrower (i) covering each of the Oil and Gas
Properties of the Borrower and its Subsidiaries (including the Barnett Shale
Properties) and detailing on a monthly basis (A) the production, revenue,
and price information and associated operating expenses for each such month, (B) any
changes to any producing reservoir, production equipment, or producing well
during each such month, which changes could cause a Material Adverse Change,
and (C) any sales of the Borrower’s or any Subsidiaries’ Oil and Gas
Properties during each such month, (ii) setting forth a true and complete
list of all Hedge Contracts of the Borrower and its Subsidiaries and detailing
the material terms thereof (including the type, term, effective date, termination
date and notional amounts or volumes), the net mark to market value thereof,
all credit support agreements relating thereto (including any margin required
or supplied), and the counterparty to each such agreement, and (iii) certifying
the Borrower’s compliance with Section 5.12 hereof.

(l)            Section 6.18
of the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.18         Leverage Ratio. The Borrower
shall not permit the Leverage Ratio at the end of each fiscal quarter ending on
or after March 31, 2007 to be greater than 5.00 to 1.00.

(m)          Section 6.19 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.19         Interest Coverage Ratio. The
Borrower (a) shall not permit the ratio of, as of the fiscal quarter
ending June 30, 2006, (i) the consolidated EBITDA of the Borrower for
the fiscal quarter period then ended multiplied by four, to (ii) the
consolidated Interest Expense of the Borrower for the fiscal quarter period
then ended multiplied by four, to be less than 1.25 to 1.00; (b) shall not
permit the ratio of, as of the fiscal quarter ending September 30, 2006, (i) the
consolidated EBITDA of the Borrower for the two fiscal quarter period then
ended multiplied by two, to (ii) the consolidated Interest Expense of the
Borrower for the two fiscal quarter period then ended multiplied by two, to be
less than 1.25 to 1.00; (c) shall not permit the ratio of, as of the
fiscal quarter ending December 31, 2006, (i) the consolidated EBITDA
of the Borrower for the three fiscal quarter period then ended multiplied by
4/3, to (ii) the consolidated Interest Expense of the Borrower for the
three fiscal quarter period then ended multiplied by 4/3, to be less than 1.25
to 1.00; (d) shall not permit the ratio of, as of the fiscal quarter
ending March 31, 2007, (i) the consolidated EBITDA of the Borrower
calculated for the four fiscal quarters then ended, to (ii) the
consolidated Interest Expense of the Borrower for the four fiscal quarters then
ended, to be less than 1.50 to 1.00; and (e) shall not permit the ratio
of, as of the end of any fiscal quarter ending on or after June 30, 2007, (i) the
consolidated EBITDA of the Borrower calculated for the four fiscal quarters
then ended, to (ii) the consolidated Interest Expense of the Borrower for
the four fiscal quarters then ended, to be less than 2.00 to 1.00.

 5
 

 

(n)           Section 7.01 of
the Credit Agreement is hereby amended by replacing clause (c)(i) in its
entirety with the following:

(i) perform or observe any
covenant contained in Section 5.02(a), Section 5.03, Section 5.06(e),
Section 5.09, Section 5.12, or Article VI of this Agreement or

(o)           Exhibit B — Compliance
Certificate and Schedule 4.07, which are attached to the Credit Agreement, are
hereby replaced in their entirety with the corresponding Exhibit B —
Compliance Certificate and Schedule 4.07 attached to this Amendment.

Section 18.            Consent
to Amendment Terms of the Senior Debt. As required under Section 6.20 of the
Credit Agreement, the Lenders hereby consent to the terms of the Amendment No. 4
to Senior Credit Agreement dated as of June 30, 2006, an execution version
of which is attached hereto as Exhibit A.

Section 19.            Borrower Representations and
Warranties.
The Borrower represents and
warrants that: (a) after giving effect to this Amendment, the
representations and warranties contained in the Credit Agreement and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of such
earlier date; (b) after giving effect to this Amendment, no Default has
occurred and is continuing; (c) the
execution, delivery and performance of this Amendment are within the corporate
power and authority of the Borrower and have been duly authorized by
appropriate corporate and governing action and proceedings; (d) this
Amendment constitutes the legal, valid, and binding obligation of the Borrower
enforceable in accordance with its terms, except as limited by applicable
bankruptcy, insolvency, reorganization, moratorium, or similar laws affecting
the rights of creditors generally and general principles of equity; (e) there
are no governmental or other third party consents, licenses and approvals
required in connection with the execution, delivery, performance, validity and
enforceability of this Amendment; and (f) the Liens under the Security
Instruments are valid and subsisting and secure Borrower’s obligations under
the Loan Documents.

Section 20.            Guarantors Representations
and Warranties. Each
Guarantor represents and warrants that: (a) after giving effect to this
Amendment, the representations and warranties contained in the Guaranty and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of
such earlier date; (b) after giving effect to this Amendment, no Default
has occurred and is continuing; (c) the execution, delivery and
performance of this Amendment are within the corporate, limited liability
company, or partnership power and authority of such Guarantor and have been
duly authorized by appropriate corporate, limited liability company, or
partnership action and proceedings; (d) this Amendment constitutes the
legal, valid, and binding obligation of such Guarantor enforceable in
accordance with its terms, except as limited by applicable bankruptcy,
insolvency, reorganization, moratorium, or similar laws affecting the rights of
creditors generally and general principles of 

 6
 

 

equity; (e) there are
no governmental or other third party consents, licenses and approvals required
in connection with the execution, delivery, performance, validity and
enforceability of this Amendment; (f) it has no defenses to the
enforcement of the Guaranty; and (g) the Liens under the Security Instruments
are valid and subsisting and secure such Guarantor’s and the Borrower’s
obligations under the Loan Documents.

Section 21.            Conditions to Effectiveness. This Amendment and the amendments to the
Credit Agreement provided herein shall become effective on the Effective Date
and enforceable against the parties hereto upon the occurrence of the following
conditions precedent:

(a)           The Administrative Agent shall have
received multiple original counterparts, as requested by the Administrative
Agent, of this Amendment duly and validly executed and delivered by duly
authorized officers of the Borrower, the Guarantors, the Administrative Agent,
and the Lenders.

(b)           The representations
and warranties in this Amendment shall be true and correct in all material respects.

(c)           The
Borrower shall have paid (i) all fees and expenses of the Administrative
Agent’s outside legal counsel and other consultants pursuant to all invoices
presented for payment on or prior to the Effective Date, and (ii) a
transaction fee in the aggregate of 1% of the principal amount of the Advance
to the Lenders.

Section 22.            Acknowledgments and
Agreements.

(d)           The Borrower acknowledges that on the
date hereof all Obligations are payable without defense, offset, counterclaim
or recoupment.

(e)           The Administrative
Agent and the Lenders hereby expressly reserve all of their rights, remedies,
and claims under the Loan Documents. Nothing in this Amendment shall constitute
a waiver or relinquishment of (i) any Default or Event of Default under
any of the Loan Documents, (ii) any of the agreements, terms or conditions
contained in any of the Loan Documents, (iii) any rights or remedies of
the Administrative Agent or any Lender with respect to the Loan Documents, or (iv) the
rights of the Administrative Agent or any Lender to collect the full amounts
owing to them under the Loan Documents.

(f)            Each of the
Borrower, the Guarantors, Administrative Agent, and Lenders does hereby adopt,
ratify, and confirm the Credit Agreement, as amended hereby, and acknowledges
and agrees that the Credit Agreement, as amended hereby, is and remains in full
force and effect, and the Borrower and the Guarantors acknowledge and agree
that their respective liabilities and obligations under the Credit Agreement,
as amended hereby, and the Guaranty, are not impaired in any respect by this
Amendment.

(g)           From and after the
Effective Date, all references to the Credit Agreement and the Loan Documents
shall mean such Credit Agreement and such Loan Documents as amended by this
Amendment.

 7
 

 

(h)           This Amendment is a
Loan Document for the purposes of the provisions of the other Loan Documents. Without
limiting the foregoing, any breach of representations, warranties, and
covenants under this Amendment shall be a Default or Event of Default, as
applicable, under the Credit Agreement.

Section 23.            Reaffirmation of the
Guaranty. Each Guarantor
hereby ratifies, confirms, acknowledges and agrees that its obligations under
the Guaranty are in full force and effect and that such Guarantor continues to
unconditionally and irrevocably guarantee the full and punctual payment, when
due, whether at stated maturity or earlier by acceleration or otherwise, all of
the Guaranteed Obligations (as defined in the Guaranty), as such Guaranteed
Obligations may have been amended by this Amendment, and its execution and
delivery of this Amendment does not indicate or establish an approval or
consent requirement by such Guarantor under the Guaranty in connection with the
execution and delivery of amendments, consents or waivers to the Credit
Agreement, the Notes or any of the other Loan Documents.

Section 24.            Counterparts.
This Amendment may be
signed in any number of counterparts, each of which shall be an original and
all of which, taken together, constitute a single instrument. This Amendment
may be executed by facsimile signature and all such signatures shall be
effective as originals.

Section 25.            Successors
and Assigns. This
Amendment shall be binding upon and inure to the benefit of the parties hereto
and their respective successors and assigns permitted pursuant to the Credit
Agreement.

Section 26.            Invalidity.
In the event that any
one or more of the provisions contained in this Amendment shall for any reason
be held invalid, illegal or unenforceable in any respect, such invalidity,
illegality or unenforceability shall not affect any other provision of this
Amendment.

Section 27.            Governing
Law. This
Amendment shall be deemed to be a contract made under and shall be governed by
and construed in accordance with the laws of the State of Texas.

Section 28.            Entire Agreement. THIS
AMENDMENT, THE CREDIT AGREEMENT AS AMENDED BY THIS AMENDMENT, THE NOTES, AND
THE OTHER LOAN DOCUMENTS CONSTITUTE THE ENTIRE UNDERSTANDING AMONG THE PARTIES
HERETO WITH RESPECT TO THE SUBJECT MATTER HEREOF AND SUPERSEDE ANY PRIOR
AGREEMENTS, WRITTEN OR ORAL, WITH RESPECT THERETO.

THERE
ARE NO UNWRITTEN ORAL AGREEMENTS AMONG THE PARTIES.

[SIGNATURES
BEGIN ON NEXT PAGE]

 

 8

 

 

EXECUTED effective
as of the date first above written.

	
  BORROWER:

  	
  CANO PETROLEUM, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  Chief Executive Officer

  

 

[Signature Page 1 of 4]

 

 

	
  GUARANTORS:

  	
  SQUARE ONE ENERGY, INC.

  
	
   

  	
  LADDER COMPANIES, INC.

  
	
   

  	
  W.O. ENERGY OF NEVADA, INC.

  
	
   

  	
  WO ENERGY, INC.

  
	
   

  	
  PANTWIST, LLC

  
	
   

  	
   

  	
   

  
	
   

  	
  Each by:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. OPERATING COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. PRODUCTION COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
				

 

[Signature Page 2
of 4]

 

 

	
  LENDER AND 

  ADMINISTRATIVE AGENT:

  	
  ENERGY COMPONENTS SPC EEP ENERGY 

  EXPLORATION AND PRODUCTION 

  SEGREGATED PORTFOLIO

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
  Name:

  	
   

  
	
   

  	
  Title:

  	
  Authorized Signer

  

 

[Signature Page 3 of 4]

 

 

	
  LENDER:

  	
  UNIONBANCAL EQUITIES, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  Michael A. Ross

  
	
   

  	
   

  	
  Vice President

  

 

 

SCHEDULE I

PRICING GRID

Applicable Margins

	
  Utilization Level*

  	
   

  	
  Base Rate

  Advances

  	
   

  	
  Eurodollar Rate

  Advances

  	
   

  	
  Commitment Fee

  	
   

  
	
  Level I

  	
   

  	
  1.00

  	
  %

  	
  2.50

  	
  %

  	
  0.50

  	
  %

  
	
  Level II

  	
   

  	
  1.25

  	
  %

  	
  2.75

  	
  %

  	
  0.375

  	
  %

  
	
  Level III

  	
   

  	
  1.50

  	
  %

  	
  3.00

  	
  %

  	
  0.375

  	
  %

  
	
  Level IV

  	
   

  	
  1.75

  	
  %

  	
  3.25

  	
  %

  	
  0.375

  	
  %

  

*                    Utilization
Levels are described below and are determined in accordance with the definition
of “Utilization Level”.

1.                  Level I: If the Utilization Level is less
than 50%.

2.                  Level II: If the Utilization Level is
greater than or equal to 50% but less than 75%.

3.                  Level III: If the Utilization Level is
greater than or equal to 75% but less than 90%.

4.                  Level IV: If the Utilization Level is
greater than or equal to 90%.

 

EXHIBIT B

FORM OF
COMPLIANCE CERTIFICATE

FOR THE PERIOD FROM               ,
200     TO                 ,
200    

This certificate dated as of                       
      ,           
is prepared pursuant to the Credit Agreement dated as of November 29, 2005
(as amended, supplemented or otherwise modified from time to time, the “Credit
Agreement”) among CANO PETROLEUM, INC., a Delaware corporation (“Borrower”),
the lenders party thereto (the “Lenders”), and UNION BANK OF CALIFORNIA, N.A.,
as administrative agent for such Lenders (in such capacity, the “Administrative
Agent”) and as issuing lender. Unless otherwise defined in this
certificate, capitalized terms that are defined in the Credit Agreement shall
have the meanings assigned to them by the Credit Agreement.

The undersigned hereby certifies that:

(a)                                  all
of the representations and warranties made by the Borrower in the Credit
Agreement and the other Loan Documents are true and correct in all material
respects as if made on this date, except to the extent that any such
representation or warranty expressly relates solely to an earlier date, in
which case it shall have been true and correct in all material respects as of
such earlier date;

[(b)     that no Default or Event of Default has
occurred and is continuing; and]

[(b)     the following Default[s] or Event[s] of Default
exist as of the date hereof or have occurred since the date of the Borrower’s
previous certification to the Administrative Agent, if any, and the actions set
forth below have been or are being taken to remedy such circumstances:

                                                                        ;
and]

(c) that as of the
last day of the previous quarter the following statements, amounts, and
calculations were true and correct:

I.                                         Current
Ratio—Section 6.17.

	
  (a)  consolidated
  current assets(1)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (b)  consolidated
  current liabilities(2)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Current Ratio =
  (a) to (b) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Minimum Current Ratio
  not less than:

  	
   

  	
  1.00 to 1.00

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES      NO

  	
   

  

 

II.            Leverage
Ratio—Section 6.18.

	
  (a)  consolidated
  Debt(3)

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (b)  consolidated
  EBITDA(4) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  

(1)             “current
assets” shall include the aggregate Unused Commitment Amounts of the
Lenders, but shall exclude (A) any cash deposited with or at the request of a
counterparty to any Hedge Contract or any other similar hedge arrangement and
(B) any assets representing a valuation account arising from the application of
SFAS 133 and 143.

(2)             “current
liabilities” shall exclude, as of the date of calculation, the current portion
of long-term Debt existing under the Credit Agreement and any liabilities
representing a valuation account arising from the application of SFAS 133 and
143.

(3)             If
an Equity Issuance of preferred Equity Interests has occurred in compliance
with Section 6.22 of the Credit Agreement and the Subordinated Debt has been
paid in full, then "consolidated Debt" shall not include such Equity
Issuance.

(4)             EBITDA
shall be measured by the four fiscal quarter period then ended.  Furthermore, (a) for the fiscal quarter
ending March 31, 2006, EBITDA shall be calculated using EBITDA for the fiscal
quarter period then ended multiplied by 4; 
(b) for the fiscal quarter ending June 30, 2006, EBITDA shall be
calculated using EBITDA for the two fiscal quarter period then ended multiplied
by 2; (c) for the fiscal quarter ending September 30, 2006, EBITDA shall be
calculated using EBITDA for the three fiscal quarter period then ended
multiplied by 4/3 and (d) for fiscal quarters ending on or after December 31,
2006, EBITDA shall be calculated using EBITDA for the four fiscal quarters then
ended.

 

 

 

	
  (i)  +
  [(ii) + (iii) + (iv)](5) - (v) =

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (i)  Consolidated
  Net Income

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (ii)  consolidated
  Interest Expense

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (iii)  taxes

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (iv)  depreciation,
  amortization, depletion & other non-cash items(6)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (v)  all
  non-cash items of income included in determining Consolidated Net Income(7)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Leverage Ratio =
  (a) to (b) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Maximum Leverage Ratio:

  	
   

  	
  [7.50
  to 1.00] [7.00 to 1.00]

  [5.00 to 1.00](8)

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES      NO

  	
   

  

(5)             Items
(ii) – (iv) shall be included to the extent deducted in determining Consolidated
Net Income.

(6)             Other
non-cash items should include any provisions for the reduction in the carrying
value of assets recorded in accordance with GAAP and including non-cash charges
resulting from the requirements of SFAS 133 or 143.

(7)             Non-cash
items of income should include any items resulting from the requirements of
SFAS 133 or 143.

(8)             If
a Debt Issuance has occurred and the Subordinated Debt has been paid in full,
then use (i) 7.50 to 1.00 for fiscal quarter ending March 31, 2007, (ii) 7.00
to 1.00 for fiscal quarter ending June 30, 2007 and (iii) 5.00 to 1.00 for
fiscal quarters ending on or after September 30, 2007.  If a Debt Issuance has not occurred, then use
5.00 to 1.00 for all fiscal quarters ending on or after March 31, 2007.

 

 

III.           Interest
Coverage Ratio—Section 6.19.

	
  (a)  consolidated
  EBITDA = See II(b) above =

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (b)  consolidated
  Interest Expense(9) =

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Interest Coverage Ratio
  = (a) to (b) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Minimum Interest
  Coverage Ratio =

  	
   

  	
  [1.25
  to 1.00]

  [1.50 to 1.00] [2.00 to 1.00](10)

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES      NO

  	
   

  

(9)             (a)
for the fiscal quarter ending June 30, 2006, Interest Expense shall be
calculated using Interest Expense for the fiscal quarter period then ended
multiplied by 4;  (b) for the fiscal
quarter ending September 30, 2006, Interest Expense shall be calculated using Interest
Expense for the two fiscal quarter period then ended multiplied by 2; (c) for
the fiscal quarter ending December 31, 2006, Interest Expense shall be
calculated using Interest Expense for the three fiscal quarter period then
ended multiplied by 4/3 and (d) for fiscal quarters ending on or after March
31, 2007, Interest Expense shall be calculated using Interest Expense for the
four fiscal quarters then ended.

(10)       Use
(a) 1.25 to 1.00 for fiscal quarters ending on or after June 30, 2006 but prior
to March 31, 2007, (b) 1.50 to 1.00 for fiscal quarter ending March 31, 2007,
and (c) 2.00 to 1.00 for fiscal quarters ending on or after June 30, 2007.

IN WITNESS THEREOF, I have hereto signed my name to
this Compliance Certificate as of                                   ,
20        .

	
  

  	
  CANO PETROLEUM, INC., a Delaware 

  corporation

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
  Name:

  	
   

  
	
   

  	
  Title:

  	
   

  

 

 

EXHIBIT F

FORM OF NOTICE OF BORROWING

[Date]

Union Bank of California,
N.A., as Administrative Agent

445 South Figueroa Street, 15th Floor

Los Angeles, California 90071

Attention:              [LOAN PROCESSOR]

Ladies and Gentlemen:

The undersigned, Cano
Petroleum, Inc., a Delaware corporation (the “Borrower”), refers to
the Credit Agreement dated as of November 29, 2005 (as the same has been
and may be amended, restated or modified from time-to-time, the “Credit
Agreement,” the defined terms of which are used in this Notice of Borrowing
unless otherwise defined in this Notice of Borrowing) among the Borrower, the
lenders party thereto (the “Lenders”), and Union Bank of California,
N.A., as administrative agent for the Lenders (the “Administrative Agent”)
and as issuing lender for the Lenders (the “Issuing Lender”), and hereby
gives you irrevocable notice pursuant to Section 2.03(a) of the
Credit Agreement that the undersigned hereby requests a Borrowing, and in
connection with that request sets forth below the information relating to such
Borrowing (the “Proposed Borrowing”) as required by Section 2.03(a) of
the Credit Agreement:

Section 29.                                   The
Business Day of the Proposed Borrowing is                           ,
          .

Section 30.                                   The
Proposed Borrowing will be composed of [Reference Rate Advances] [Eurodollar
Rate Advances].

Section 31.                                   The
aggregate amount of the Proposed Borrowing is $                        .

Section 32.                                   [The
Interest Period for each Eurodollar Rate Advance made as part of the Proposed
Borrowing is [          
month[s]].]

The Borrower hereby
certifies that the following statements are true on the date hereof, and will
be true on the date of the Proposed Borrowing:

(a)                                  the
representations and warranties contained in Article IV of the Credit
Agreement and the representations and warranties contained in the Security
Instruments, the Guaranties, and each of the other Loan Documents are true and
correct in all material respects on and as of the date of the Proposed
Borrowing, before and after giving effect to the Proposed Borrowing and to the
application of the proceeds from the Proposed Borrowing, as though made on and
as of such date, except to the extent that any such representation or warranty
expressly relates solely to an earlier date, in which case it shall have been
true and correct in all material respects as of such earlier date;

 

(b)                                 no
Default has occurred and is continuing or would result from the Proposed
Borrowing or from the application of the proceeds therefrom;

(c)                                  [the
proceeds of the Proposed Borrowing are not to be used to fund a capital
expenditure] [the proceeds of the Proposed Borrowing are to be used to fund a
capital expenditure which has been approved by the Lenders pursuant to an
approval letter, a copy of which is attached as Exhibit A hereto]; and

(d)                                 $                            
of the Proposed Borrowing will be used for general corporate or working capital
purposes and, after giving effect to such application of proceeds, the General
Corporate Advance Amount is not in excess of $10,000,000.

	
  

  	
  Very truly yours,

  
	
   

  	
   

  
	
   

  	
  CANO PETROLEUM, INC., a Delaware 

  corporation

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
  Name:

  	
   

  
	
   

  	
  Title:

  	
   

  

 

 

APPROVAL
LETTER

Reference is made
to the Credit Agreement dated as of November 29, 2005 (as the same has
been and may be amended, restated or modified from time-to-time, the “Credit
Agreement,”) among Cano Petroleum, Inc., a Delaware corporation (the “Borrower”),
the lenders party thereto (the “Lenders”), and Union Bank of California,
N.A., as administrative agent for the Lenders (the “Administrative Agent”)
and as issuing lender for the Lenders (the “Issuing Lender”). Reference
is hereby made to the Credit Agreement for all purposes, and terms defined
therein shall have the same meanings when used herein. The Credit Agreement
provides that the Borrower may not use the proceeds of any Advance to fund
capital expenditures unless such capital expenditures are approved in writing
by the Lenders. This letter shall evidence the Lenders approval of the capital
expenditures which are specified below or specified in the schedule attached
hereto:

[specify
capital expenditures with a description, date of incurrence, amount, oil and
gas property affected thereby, and such other information as the Lenders may
request]

This letter is a Loan
Document, and all provisions of the Credit Agreement which apply to Loan
Documents shall apply hereto. This letter may be separately executed in any
number of counterparts and by the different parties hereto in separate
counterparts, each of which when so executed shall be deemed to constitute one
and the same agreement.

Please execute a
counterpart of this letter in the place provided below to evidence your
agreement to the foregoing and your continuing ratification of the Credit
Agreement and the other Loan Documents in consideration of the approval herein
contained.

Yours truly,

	
  UNION BANK OF CALIFORNIA, N.A.

  	
   

  	
  NATEXIS BANQUES POPULAIRES

  
	
   

  	
   

  	
   

  	
   

  	
   

  
	
  By:

  	
   

  	
   

  	
  By:

  	
   

  
	
  Name:

  	
   

  	
   

  	
  Name:

  	
   

  
	
  Title:

  	
   

  	
   

  	
  Title:

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
   

  	
  Name:

  	
   

  
	
   

  	
   

  	
   

  	
  Title:

  	
   

  

 

*[OTHER LENDERS, IF ANY]

Accepted and agreed to as of the date first written
above

	
  CANO PETROLEUM, INC.

  	
   

  
	
   

  	
   

  	
   

  
	
  By:

  	
   

  	
   

  
	
  Name:

  	
   

  	
   

  
	
  Title:

  	
   

  	
   

  

 

 

Schedule 4.07

Litigation

On March 23, 2006,
the following lawsuit was filed in the 100th Judicial District Court in Carson County,
Texas; Cause No. 9840, The Tom L. and Anne Burnett Trust, by Anne Burnett
Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, III and Ed
Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and Burnett Ranches,
Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O.
Operating Company, Ltd, and W.O. Energy, Inc.

On April 28, 2006,
the following lawsuit was filed in the 31st Judicial District Court of Roberts County,
Texas, Case No. 1922, Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc.,
W.O. Energy of Nevada, Inc.; W. O. Operating Company, Ltd, and W.O. Energy, Inc.

On April 10, 2006,
the following lawsuit was filed in the 31st Judicial District Court of Roberts County,
Texas, Case No. 1920, Joseph Craig Hutchison and Judy Hutchison v. Cano
Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O. Operating
Company, Ltd, and W.O. Energy, Inc.

On May 1, 2006, the
following lawsuit was filed in the 31st Judicial District Court of Roberts County,
Texas, Case No. 1923, Chisum Family Partnership, Ltd. v. Cano Petroleum, Inc.,
W.O. Energy of Nevada, Inc.; W. O. Operating Company, Ltd, and W.O. Energy, Inc.

The plaintiffs in the
above actions claim that the electrical wiring and equipment of Cano Petroleum, Inc.
or certain of its subsidiaries relating to its oil and gas operations started a
wildfire that began on March 12, 2006 in Carson County, Texas. The
plaintiffs (i) allege negligence and gross negligence and (ii) seek
undisclosed damages, including, but not limited to, damages for damage to their
land and livestock, certain expenses related to fighting the fire and certain
remedial expenses. In addition, certain plaintiffs seek (i) termination of
certain oil and gas leases, (ii) reimbursement for their attorney’s fees
and (iii) exemplary damages.THIRD
AMENDMENT TO SUBORDINATED CREDIT AGREEMENT

This THIRD AMENDMENT TO SUBORDINATED CREDIT AGREEMENT (“Amendment”)
entered into and made effective as of June 30, 2006 (“Effective Date”) is
among Cano Petroleum, Inc., a Delaware corporation (“Borrower”), the
Guarantors (as defined below), the Lenders (as defined below), and Energy
Components SPC EEP Energy Exploration and Production Segregated Portfolio, a
Cayman Islands company, as administrative agent for such Lenders (in such
capacity, the “Administrative Agent”).

RECITALS

A.            The Borrower is party to that
certain Subordinated Credit Agreement dated as of November 29, 2005, as
amended by the First Amendment to Subordinated Credit Agreement dated as of April 28,
2006 and the Second Amendment to Subordinated Credit Agreement entered into on May 12,
2006 but made effective as of March 31, 2006 (as so amended, the “Credit
Agreement”) among the Borrower, the lenders party thereto from time to time
(the “Lenders”), and the Administrative Agent.

B.            The Borrower, the Lenders and the
Administrative Agent wish to, subject to the terms and conditions of this
Amendment, make certain amendments to the Credit Agreement as provided herein.

THEREFORE,
the Borrower, the Guarantors, the Lenders, and the Administrative Agent hereby
agree as follows:

Section 1.              Defined
Terms. As used in
this Amendment, each of the terms defined in the opening paragraph and the
Recitals above shall have the meanings assigned to such terms therein. Each
term defined in the Credit Agreement and used herein without definition shall
have the meaning assigned to such term in the Credit Agreement, unless
expressly provided to the contrary.

Section 2.              Other
Definitional Provisions. Article, Section, Schedule, and Exhibit references are to Articles
and Sections of and Schedules and Exhibits to this Amendment, unless otherwise
specified. All references to instruments, documents, contracts, and agreements
are references to such instruments, documents, contracts, and agreements as the
same may be amended, supplemented, and otherwise modified from time to time,
unless otherwise specified. The words “hereof”, “herein”, and “hereunder” and
words of similar import when used in this Amendment shall refer to this
Amendment as a whole and not to any particular provision of this Amendment. The
term “including” means “including, without limitation,”. Paragraph headings
have been inserted in this Amendment as a matter of convenience for reference
only and it is agreed that such paragraph headings are not a part of this Amendment
and shall not be used in the interpretation of any provision of this Amendment.

 

Section 3.              Amendments to Credit
Agreement.

(a)           Section 1.01 of
the Credit Agreement is amended by replacing the definitions of “Applicable
Margin” and “Maturity Date” in their entirety with the following corresponding
terms:

“Applicable Margin” means,
with respect to any Advance, (a) during any time when an Event of Default
exists, 9.5% per annum, (b) during any time which the Leverage Ratio is
greater than 4.00 to 1.00, 8.0% per annum, provided that for each calendar
quarter beginning on October 1, 2006 for which the Leverage Coverage Ratio
is greater than 4.00 to 1.00, such 8.0% per annum rate shall increase by .25%
on the first day of such calendar quarter to a maximum of 9.5% per annum, and (c) at
any time other than as provided in (a) and (b) above, 6.5% per annum.

“Maturity Date” means the
earlier of (i) November 28, 2009, or (ii) one year after the “Maturity
Date” as defined in the Senior Credit Agreement.

(b)           Section 1.01 of
the Credit Agreement is further amended by inserting the following new
definitions in alphabetical order:

“Debt Issuance” means the issuance by the Borrower of Debt in
the form of convertible notes.

“Debt Issuance Proceeds” means, with respect to any Debt
Issuance, all cash and cash equivalent investments received by the Borrower
from such Debt Issuance after payment of, or provision for, all underwriter
fees and expenses, SEC and blue sky fees, printing costs, fees and expenses of
accountants, lawyers and other professional advisors, brokerage commissions and
other out-of-pocket fees and expenses actually incurred in connection with such
Debt Issuance.

“Equity Issuance” means any issuance of equity securities or any
other Equity Interests (including any preferred equity securities) by the
Borrower or any of its Subsidiaries other than equity securities issued (i) to
the Borrower or one of its Subsidiaries and (ii) pursuant to employee or
director and officer stock option plans in the ordinary course of business.

“Equity Issuance Proceeds” means, with respect to any Equity
Issuance, all cash and cash equivalent investments received by the Borrower or
any of its Subsidiaries from such Equity Issuance after payment of, or
provision for, all underwriter fees and expenses, SEC and blue sky fees,
printing costs, fees and expenses of accountants, lawyers and other
professional advisors, brokerage commissions and other out-of-pocket fees and
expenses actually incurred in connection with such Equity Issuance.

“Junior Capital Issuance” means either (a) an Equity
Issuance (b) a Debt Issuance.

“Leverage Ratio” means, as of the end of any fiscal quarter, the
ratio of (a) the consolidated Debt of the Borrower as of such fiscal
quarter end to (b) the 

 2
 

 

consolidated EBITDA of the Borrower for the four fiscal quarter period
then ended.

(c)           The first sentence
of Section 2.03 of the Credit Agreement is hereby amended by replacing it
in its entirety with the following:

Section 2.03         Prepayment of Advance. Borrower
may prepay all, but not less than all, of the outstanding Advance during the
first year following the Effective Date (or any subsequent year pursuant to a
Junior Capital Issuance), after giving by 10:00 a.m. (Dallas, Texas time)
at least three Business Days’ irrevocable prior written notice to the
Administrative Agent stating the proposed date of such prepayment. If any such
notice is given, the Borrower shall prepay the Advance in its entirety by
delivering to the Administrative Agent an amount equal to 101% of the amount of
the Advance, together with accrued interest to the date of such prepayment on
the principal amount prepaid and amounts, if any, required to be paid pursuant
to Section 2.09 as a result of such prepayment being made on such date.

(d)           Section 2.03
of the Credit Agreement is hereby further amended by adding the following new
clause (c) to the end thereof:

(c)           Junior Capital Issuance. If the Borrower or any
Subsidiary receives Debt Issuance Proceeds or Equity Issuance Proceeds, then
immediately upon receipt of such proceeds, the Borrower shall prepay the
Advance, along with accrued interest and such fees as set forth in the first
two sentences of Section 2.03 above, in its entirety.

(e)           Section 5.06(b) of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

(b)          Monthly Financials. As soon as available and in any
event not later than 45 days after the end of each calendar month, commencing
with June 30, 2006, (i) the unaudited balance sheet and the
statements of income, cash flows, and retained earnings of each such Person for
the period commencing at the end of the previous year and ending with the end
of such calendar month, all in reasonable detail and duly certified with
respect to such consolidated statements (subject to year-end audit
adjustments) by a Responsible Officer of the Borrower as having been prepared
in accordance with GAAP, (ii) for each calendar month end that is also a
fiscal quarter end (and that is not a fiscal year end), the Form 10-QSB
filed with the SEC for such fiscal quarter end, and (iii) a Compliance
Certificate executed by the Responsible Officer of the Borrower;

(f)            Section 5.06(d) of
the Credit Agreement is deleted in its entirety and replaced with the
following:

(d)          Production and Hedging Reports. As soon as available
and in any event within 45 days after the end of each calendar month,
commencing with June 30, 2006, a report certified by a Responsible Officer
of the Borrower in form and 

 3
 

 

substance satisfactory to the
Administrative Agent prepared by the Borrower (i) covering each of the Oil
and Gas Properties of the Borrower and its Subsidiaries (including the Barnett
Shale Properties) and detailing on a monthly basis (A) the production,
revenue, and price information and associated operating expenses for each such
month, (B) any changes to any producing reservoir, production equipment,
or producing well during each such month, which changes could cause a Material
Adverse Change, and (C) any sales of the Borrower’s or any Subsidiaries’
Oil and Gas Properties during each such month, (ii) setting forth a true
and complete list of all Hedge Contracts of the Borrower and its Subsidiaries
and detailing the material terms thereof (including the type, term, effective
date, termination date and notional amounts or volumes), the net mark to market
value thereof, all credit support agreements relating thereto (including any
margin required or supplied), and the counterparty to each such agreement, and (iii) certifying
the Borrower’s compliance with Section 5.12 hereof.

(g)           Section 6.18 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.18         Leverage Ratio. The Borrower
shall not permit the Leverage Ratio at the end of each fiscal quarter ending on
or after March 31, 2007 to be greater than 5.00 to 1.00.

(h)           Section 6.19 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.19         Interest Coverage Ratio. The
Borrower (a) shall not permit the ratio of, as of the fiscal quarter
ending June 30, 2006, (i) the consolidated EBITDA of the Borrower for
the fiscal quarter period then ended multiplied by four, to (ii) the
consolidated Interest Expense of the Borrower for the fiscal quarter period
then ended multiplied by four, to be less than 1.25 to 1.00; (b) shall not
permit the ratio of, as of the fiscal quarter ending September 30, 2006, (i) the
consolidated EBITDA of the Borrower for the two fiscal quarter period then
ended multiplied by two, to (ii) the consolidated Interest Expense of the
Borrower for the two fiscal quarter period then ended multiplied by two, to be
less than 1.25 to 1.00; (c) shall not permit the ratio of, as of the
fiscal quarter ending December 31, 2006, (i) the consolidated EBITDA
of the Borrower for the three fiscal quarter period then ended multiplied by
4/3, to (ii) the consolidated Interest Expense of the Borrower for the
three fiscal quarter period then ended multiplied by 4/3, to be less than 1.25
to 1.00; (d) shall not permit the ratio of, as of the fiscal quarter
ending March 31, 2007, (i) the consolidated EBITDA of the Borrower
calculated for the four fiscal quarters then ended, to (ii) the
consolidated Interest Expense of the Borrower for the four fiscal quarters then
ended, to be less than 1.50 to 1.00; and (e) shall not permit the ratio
of, as of the end of any fiscal quarter ending on or after June 30, 2007, (i) the
consolidated EBITDA of the Borrower calculated for the four fiscal quarters
then ended, to (ii) the consolidated Interest Expense of the Borrower for
the four fiscal quarters then ended, to be less than 2.00 to 1.00.

 4
 

 

(i)            Section 7.01
of the Credit Agreement is hereby amended by replacing clause (c)(i) in
its entirety with the following:

 (i) perform or observe any covenant contained
in Section 5.02(a), Section 5.03, Section 5.06(e), Section 5.09,
Section 5.12, or Article VI of this Agreement or

(j)            Exhibit B — Compliance
Certificate and Schedule 4.07, which are attached to the Credit Agreement, are
hereby replaced in their entirety with the corresponding Exhibit B —
Compliance Certificate and Schedule 4.07 attached to this Amendment.

Section 4.              Consent
to Amendment Terms of the Senior Debt. As required under Section 6.20 of the
Credit Agreement, the Lenders hereby consent to the terms of the Amendment No. 4
to Senior Credit Agreement dated as of June 30, 2006, an execution version
of which is attached hereto as Exhibit A.

Section 5.              Borrower Representations and
Warranties.
The Borrower represents and
warrants that: (a) after giving effect to this Amendment, the
representations and warranties contained in the Credit Agreement and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of
such earlier date; (b) after giving effect to this Amendment, no Default
has occurred and is continuing; (c) the
execution, delivery and performance of this Amendment are within the corporate
power and authority of the Borrower and have been duly authorized by appropriate
corporate and governing action and proceedings; (d) this Amendment
constitutes the legal, valid, and binding obligation of the Borrower
enforceable in accordance with its terms, except as limited by applicable
bankruptcy, insolvency, reorganization, moratorium, or similar laws affecting
the rights of creditors generally and general principles of equity; (e) there
are no governmental or other third party consents, licenses and approvals
required in connection with the execution, delivery, performance, validity and
enforceability of this Amendment; and (f) the Liens under the Security
Instruments are valid and subsisting and secure Borrower’s obligations under
the Loan Documents.

Section 6.              Guarantors Representations
and Warranties. Each
Guarantor represents and warrants that: (a) after giving effect to this
Amendment, the representations and warranties contained in the Guaranty and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of
such earlier date; (b) after giving effect to this Amendment, no Default
has occurred and is continuing; (c) the execution, delivery and
performance of this Amendment are within the corporate, limited liability
company, or partnership power and authority of such Guarantor and have been
duly authorized by appropriate corporate, limited liability company, or
partnership action and proceedings; (d) this Amendment constitutes the
legal, valid, and binding obligation of such Guarantor enforceable in accordance
with its terms, except as limited by applicable bankruptcy, insolvency,
reorganization, moratorium, or similar laws affecting the rights of creditors
generally and general principles of 

 5
 

 

equity; (e) there are
no governmental or other third party consents, licenses and approvals required
in connection with the execution, delivery, performance, validity and
enforceability of this Amendment; (f) it has no defenses to the
enforcement of the Guaranty; and (g) the Liens under the Security
Instruments are valid and subsisting and secure such Guarantor’s and the
Borrower’s obligations under the Loan Documents.

Section 7.              Conditions to Effectiveness. This Amendment and the amendments to the
Credit Agreement provided herein shall become effective on the Effective Date
and enforceable against the parties hereto upon the occurrence of the following
conditions precedent:

(a)           The Administrative Agent shall have
received multiple original counterparts, as requested by the Administrative
Agent, of this Amendment duly and validly executed and delivered by duly
authorized officers of the Borrower, the Guarantors, the Administrative Agent,
and the Lenders.

(b)           The representations
and warranties in this Amendment shall be true and correct in all material
respects.

(c)           The
Borrower shall have paid (i) all fees and expenses of the Administrative
Agent’s outside legal counsel and other consultants pursuant to all invoices
presented for payment on or prior to the Effective Date, and (ii) a
transaction fee in the aggregate of 1% of the principal amount of the Advance
to the Lenders.

Section 8.              Acknowledgments and
Agreements.

(a)           The Borrower acknowledges that on the
date hereof all Obligations are payable without defense, offset, counterclaim
or recoupment.

(b)           The Administrative
Agent and the Lenders hereby expressly reserve all of their rights, remedies,
and claims under the Loan Documents. Nothing in this Amendment shall constitute
a waiver or relinquishment of (i) any Default or Event of Default under
any of the Loan Documents, (ii) any of the agreements, terms or conditions
contained in any of the Loan Documents, (iii) any rights or remedies of
the Administrative Agent or any Lender with respect to the Loan Documents, or (iv) the
rights of the Administrative Agent or any Lender to collect the full amounts
owing to them under the Loan Documents.

(c)           Each of the
Borrower, the Guarantors, Administrative Agent, and Lenders does hereby adopt,
ratify, and confirm the Credit Agreement, as amended hereby, and acknowledges
and agrees that the Credit Agreement, as amended hereby, is and remains in full
force and effect, and the Borrower and the Guarantors acknowledge and agree
that their respective liabilities and obligations under the Credit Agreement,
as amended hereby, and the Guaranty, are not impaired in any respect by this
Amendment.

(d)           From and after the
Effective Date, all references to the Credit Agreement and the Loan Documents
shall mean such Credit Agreement and such Loan Documents as amended by this
Amendment.

 6
 

 

(e)           This Amendment is a
Loan Document for the purposes of the provisions of the other Loan Documents. Without
limiting the foregoing, any breach of representations, warranties, and
covenants under this Amendment shall be a Default or Event of Default, as
applicable, under the Credit Agreement.

Section 9.              Reaffirmation of the
Guaranty. Each Guarantor
hereby ratifies, confirms, acknowledges and agrees that its obligations under
the Guaranty are in full force and effect and that such Guarantor continues to
unconditionally and irrevocably guarantee the full and punctual payment, when
due, whether at stated maturity or earlier by acceleration or otherwise, all of
the Guaranteed Obligations (as defined in the Guaranty), as such Guaranteed
Obligations may have been amended by this Amendment, and its execution and
delivery of this Amendment does not indicate or establish an approval or
consent requirement by such Guarantor under the Guaranty in connection with the
execution and delivery of amendments, consents or waivers to the Credit
Agreement, the Notes or any of the other Loan Documents.

Section 10.            Counterparts.
This Amendment may be
signed in any number of counterparts, each of which shall be an original and
all of which, taken together, constitute a single instrument. This Amendment
may be executed by facsimile signature and all such signatures shall be
effective as originals.

Section 11.            Successors
and Assigns. This
Amendment shall be binding upon and inure to the benefit of the parties hereto
and their respective successors and assigns permitted pursuant to the Credit
Agreement.

Section 12.            Invalidity.
In the event that any
one or more of the provisions contained in this Amendment shall for any reason
be held invalid, illegal or unenforceable in any respect, such invalidity,
illegality or unenforceability shall not affect any other provision of this
Amendment.

Section 13.            Governing
Law. This
Amendment shall be deemed to be a contract made under and shall be governed by
and construed in accordance with the laws of the State of Texas.

Section 14.            Entire Agreement. THIS
AMENDMENT, THE CREDIT AGREEMENT AS AMENDED BY THIS AMENDMENT, THE NOTES, AND
THE OTHER LOAN DOCUMENTS CONSTITUTE THE ENTIRE UNDERSTANDING AMONG THE PARTIES
HERETO WITH RESPECT TO THE SUBJECT MATTER HEREOF AND SUPERSEDE ANY PRIOR
AGREEMENTS, WRITTEN OR ORAL, WITH RESPECT THERETO.

THERE
ARE NO UNWRITTEN ORAL AGREEMENTS AMONG THE PARTIES.

[SIGNATURES
BEGIN ON NEXT PAGE]

 

 7

 

EXECUTED
effective as of the date first above written.

	
  BORROWER:

  	
  CANO PETROLEUM, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ S. Jeffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  Chief Executive Officer

  

 

[Signature Page 1 of 4]

 

 

	
  GUARANTORS:

  	
  SQUARE ONE ENERGY, INC.

  
	
   

  	
  LADDER COMPANIES, INC.

  
	
   

  	
  W.O. ENERGY OF NEVADA, INC.

  
	
   

  	
  WO ENERGY, INC.

  
	
   

  	
  PANTWIST, LLC

  
	
   

  	
   

  	
   

  
	
   

  	
  Each by:

  	
  /s/ S. Jeffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. OPERATING COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ S. Jeffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. PRODUCTION COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ S. Jeffrey Johnson

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
				

 

[Signature Page 2
of 4]

 

 

	
  LENDER AND 

  ADMINISTRATIVE AGENT:

  	
  ENERGY COMPONENTS SPC EEP ENERGY 

  EXPLORATION AND PRODUCTION 

  SEGREGATED PORTFOLIO

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ Michael Laznicka

  
	
   

  	
  Name:

  	
  Michael Laznicka

  
	
   

  	
  Title:

  	
  Authorized Signer: Corporate Secretary

  

 

[Signature Page 3 of 4]

 

 

	
  LENDER:

  	
  UNIONBANCAL EQUITIES, INC.

  
	
   

  	
   

  
	
   

  	
  By:

  	
  /s/ Michael A. Ross

  
	
   

  	
   

  	
  Michael A. Ross

  
	
   

  	
   

  	
  Vice President

  

 

[Signature Page 4
of 4]

 

Exhibit A

AMENDMENT
NO. 4

This AMENDMENT NO. 4 (“Agreement”) entered into and made effective as
of June 30, 2006 (“Effective Date”) is among Cano Petroleum, Inc., a
Delaware corporation (“Borrower”), the Guarantors (as defined below), the
Lenders (as defined below), and Union Bank of California, N.A., as
administrative agent for such Lenders (in such capacity, the “Administrative
Agent”) and as issuing lender (in such capacity, the “Issuing Lender”).

RECITALS

C.            The Borrower is party to that
certain Credit Agreement dated as of November 29, 2005, as amended by the
Amendment No. 1 dated as of February 24, 2006, and as amended by the
Amendment No. 2, Assignment and Agreement dated as of April 28, 2006,
and Amendment No. 3 entered into on May 12, 2006 but made effective
as of March 31, 2006 (as so amended, the “Credit Agreement”) among the
Borrower, the lenders party thereto from time to time (the “Lenders”), the
Administrative Agent, and the Issuing Lender.

D.            The Borrower, the Lenders and the
Administrative Agent wish to, subject to the terms and conditions of this
Agreement make certain amendments to the Credit Agreement as provided herein.

THEREFORE,
the Borrower, the Guarantors, the Lenders, and the Administrative Agent hereby
agree as follows:

Section 15.            Defined
Terms. As used in
this Agreement, each of the terms defined in the opening paragraph and the
Recitals above shall have the meanings assigned to such terms therein. Each
term defined in the Credit Agreement and used herein without definition shall
have the meaning assigned to such term in the Credit Agreement, unless
expressly provided to the contrary.

Section 16.            Other
Definitional Provisions. Article, Section, Schedule, and Exhibit references are to Articles
and Sections of and Schedules and Exhibits to this Agreement, unless otherwise
specified. All references to instruments, documents, contracts, and agreements
are references to such instruments, documents, contracts, and agreements as the
same may be amended, supplemented, and otherwise modified from time to time,
unless otherwise specified. The words “hereof”, “herein”, and “hereunder” and
words of similar import when used in this Agreement shall refer to this
Agreement as a whole and not to any particular provision of this Agreement. The
term “including” means “including, without limitation,”. Paragraph headings
have been inserted in this Agreement as a matter of convenience for reference
only and it is agreed that such paragraph headings are not a part of this
Agreement and shall not be used in the interpretation of any provision of this
Agreement.

 

Section 17.            Amendments to Credit
Agreement.

(f)            Section 1.01
of the Credit Agreement is amended by replacing the definitions of “Maturity
Date” and “Interest Expense” in their entirety with the following corresponding
terms:

“Maturity Date”
means November 28, 2008.

“Interest Expense” means,
for the Borrower and its consolidated Subsidiaries for any period, total
interest, letter of credit fees, and other fees and expenses incurred in
connection with any Debt for such period, whether paid or accrued, including,
without limitation, all interests, dividends, distributions or other payments
made in respect of preferred Equity Interests or Debt Issuances, and all
commissions, discounts and other fees and charges owed with respect to letters
of credit and bankers’ acceptance financing, imputed interest under Capital
Leases, and net costs under Interest Hedge Agreements, all as determined in
conformity with GAAP.

(g)           Section 1.01 of
the Credit Agreement is further amended by inserting the following new
definitions in alphabetical order:

“Debt Issuance” means the issuance by the Borrower of Debt in
the form of convertible notes.

“Debt Issuance Proceeds” means, with respect to any Debt
Issuance, all cash and cash equivalent investments received by the Borrower
from such Debt Issuance after payment of, or provision for, all underwriter
fees and expenses, SEC and blue sky fees, printing costs, fees and expenses of
accountants, lawyers and other professional advisors, brokerage commissions and
other out-of-pocket fees and expenses actually incurred in connection with such
Debt Issuance.

“Equity Issuance” means any issuance of equity securities or any
other Equity Interests (including any preferred equity securities) by the
Borrower or any of its Subsidiaries other than equity securities issued (i) to
the Borrower or one of its Subsidiaries, (ii) pursuant to employee or
director and officer stock option plans in the ordinary course of business, and
(iii) the conversion of previously issued preferred, convertible Equity
Interests or convertible notes to the extent such Equity Interests and notes
were issued in compliance with the terms hereof.

“Equity Issuance Proceeds” means, with respect to any Equity
Issuance, all cash and cash equivalent investments received by the Borrower or
any of its Subsidiaries from such Equity Issuance after payment of, or
provision for, all underwriter fees and expenses, SEC and blue sky fees,
printing costs, fees and expenses of accountants, lawyers and other
professional advisors, brokerage commissions and other out-of-pocket fees and
expenses actually incurred in connection with such Equity Issuance.

“General Corporate Advance Amount” means, as of the date of
determination, the aggregate amount of Advances outstanding on such date and
the proceeds of 

 4
 

 

which were applied by the Borrower or any of its Subsidiaries for
general corporate purposes or working capital purposes.

“Junior Capital Issuance” means either (a) an Equity
Issuance permitted under Section 6.22 or (b) a Debt Issuance.

“Leverage Ratio” means, as of the end of any fiscal quarter, the
ratio of (a) the consolidated Debt of the Borrower as of such fiscal
quarter end to (b) the consolidated EBITDA of the Borrower for the four
fiscal quarter period then ended.

“Liquidity Deposit Amount” means, at the time determination, the
aggregate amount of Equity Issuance Proceeds and Debt Issuance Proceeds which
have been deposited into a deposit account with the Administrative Agent or any
Lender or any other depository bank that has executed an account control
agreement reasonably acceptable in form and substance to the Administrative
Agent, as required under Section 5.13, regardless of whether such proceeds
are, at such time, held in such deposit account.

(h)           The first sentence of Section 2.01(a) of
the Credit Agreement is deleted in its entirety and replaced with the
following:

Each Lender severally agrees, on the terms and conditions set forth in
this Agreement, to make Advances to the Borrower from time to time on any
Business Day during the period from the date of this Agreement until the
Commitment Termination Date in an amount for each Lender not to exceed such
Lender’s Unused Commitment Amount; provided that, no Lender shall have an
obligation to make Advances if the making of such Advances would cause the
General Corporate Advance Amount to exceed $10,000,000.

(i)            The last sentence
of Section 2.02(a) of the Credit Agreement is deleted in its entirety
and replaced with the following:

The Borrowing Base shall be
determined in accordance with the standards set forth in Section 2.02(d) and
is subject to periodic redetermination pursuant to Sections 2.02(b), 2.02(c) and
2.02(e).

(j)            Section 2.02
of the Credit Agreement is hereby amended by replacing clause (e) thereof
in its entirety with the following:

(e)           In addition to the Borrowing Base redeterminations
provided for in Section 2.02(b) and Section 2.02(c), the
Administrative Agent and the Lenders may (i) in their sole discretion and
based on such information as the Administrative Agent and the Lenders deem
relevant (but in accordance with Section 2.02(d)), redetermine the
Borrowing Base upon a Junior Capital Issuance by the Borrower and (ii) in
their sole discretion and based on such information as the Administrative Agent
and the Lenders deem relevant (but in accordance with Section 2.02(d)),
redetermine the Borrowing Base if a Junior Capital Issuance by the Borrower has
not occurred on or prior to August 30, 2006. The parties hereto
acknowledge and agree that should such interim redetermination occur pursuant 

 5
 

 

to this clause (e), the Lenders
may, but are not obligated to, waive the scheduled redetermination of the
Borrowing Base which is scheduled to occur pursuant to Section 2.02(b)(i) on
September 30, 2006.

(k)           Section 2.05 of
the Credit Agreement is hereby amended by replacing clause (f) thereof in
its entirety with the following:

(f)            Debt Issuance. If the Borrower or any Subsidiary
of the Borrower receives Debt Issuance Proceeds, then immediately upon receipt
of such proceeds, the Borrower shall prepay the Advances or, if the Advances
have been repaid in full, make deposits into the Cash Collateral Account to
provide cash collateral for the Letter of Credit Exposure, in an amount equal
to (A) 100% of such Debt Issuance Proceeds minus (B) the
amount applied to satisfy outstanding Subordinated Debt minus (C) the
amount, if any, necessary to cause the Liquidity Deposit Amount at the time of
such Debt Issuance to equal $2,500,000. The prepayment required pursuant to
this Section 2.05(f) shall be accompanied by accrued interest on the
amount prepaid to the date of such prepayment and amounts, if any, required to
be paid pursuant to Section 2.12 as a result of such prepayment being made
on such date. Such prepayment shall be applied to the Advances as determined by
the Administrative Agent and agreed to by the Lenders in their sole discretion.

(l)            Section 2.05
of the Credit Agreement is hereby further amended by adding the following new
clause (g) to the end thereof

(g)          Equity Issuance. If the Borrower or any Subsidiary
of the Borrower receives Equity Issuance Proceeds, then immediately upon
receipt of such proceeds, the Borrower shall prepay the Advances or, if the
Advances have been repaid in full, make deposits into the Cash Collateral
Account to provide cash collateral for the Letter of Credit Exposure, in an
amount equal to (A) 100% of such Equity Issuance Proceeds minus (B) the
amount applied to satisfy outstanding Subordinated Debt minus (C) the
amount, if any, necessary to cause the Liquidity Deposit Amount at the time of
such Equity Issuance to equal $2,500,000. The prepayment required pursuant to
this Section 2.05(g) shall be accompanied by accrued interest on the
amount prepaid to the date of such prepayment and amounts, if any, required to
be paid pursuant to Section 2.12 as a result of such prepayment being made
on such date. Such prepayment shall be applied to the Advances as determined by
the Administrative Agent and agreed to by the Lenders in their sole discretion.

(m)          Section 5.06(b) of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

(b)          Monthly Financials. As soon as available and in any
event not later than 45 days after the end of each calendar month, commencing
with June 30, 2006, (i) the unaudited balance sheet and the
statements of income, cash flows, and retained earnings of each such Person for
the period commencing at the end of 

 6
 

 

the previous year and ending with
the end of such calendar month, all in reasonable detail and duly certified
with respect to such consolidated statements (subject to year-end audit
adjustments) by a Responsible Officer of the Borrower as having been prepared
in accordance with GAAP, (ii) for each calendar month end that is also a
fiscal quarter end (and that is not a fiscal year end), the Form 10-QSB
filed with the SEC for such fiscal quarter end, and (iii) a Compliance
Certificate executed by the Responsible Officer of the Borrower;

(n)           Section 5.06(d) of
the Credit Agreement is deleted in its entirety and replaced with the
following:

(d)          Production and Hedging Reports. As soon as available
and in any event within 45 days after the end of each calendar month,
commencing with June 30, 2006, a report certified by a Responsible Officer
of the Borrower in form and substance satisfactory to the Administrative Agent
prepared by the Borrower (i) covering each of the Oil and Gas Properties
of the Borrower and its Subsidiaries (including the Barnett Shale Properties)
and detailing on a monthly basis (A) the production, revenue, and price
information and associated operating expenses for each such month, (B) any
changes to any producing reservoir, production equipment, or producing well
during each such month, which changes could cause a Material Adverse Change,
and (C) any sales of the Borrower’s or any Subsidiaries’ Oil and Gas
Properties during each such month, (ii) setting forth a true and complete
list of all Hedge Contracts of the Borrower and its Subsidiaries and detailing the
material terms thereof (including the type, term, effective date, termination
date and notional amounts or volumes), the net mark to market value thereof,
all credit support agreements relating thereto (including any margin required
or supplied), and the counterparty to each such agreement, and (iii) certifying
the Borrower’s compliance with Section 5.12 hereof.

(o)           Section 5.09 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 5.09         Use of Proceeds. The Borrower
shall use the proceeds of the Advances and Letters of Credit (a) to
develop Oil and Gas Properties, (b) for working capital purposes and (c) for
general corporate purposes; provided that (i) the Borrower shall not use
the proceeds of any Advance for any capital expenditure unless such capital
expenditure (as determined in accordance with GAAP) is approved in writing by
the Lenders prior to the application of such proceeds to fund such capital
expenditure; and (ii) the Borrower shall not use the proceeds of any
Advance for general corporate purposes or working capital purposes unless the
use thereof for such purposes would not cause the General Corporate Advance
Amount, after the application thereof, to exceed $10,000,000.

(p)           Section 5.12 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

 7
 

 

Section 5.12         Hedging Arrangements. The
Borrower shall:

(a) maintain the Hydrocarbon
Hedge Agreements in existence on March 31, 2006 and as described in
Schedule 5.12 (or such other floors or swaps as the required by the Required
Lenders) for a minimum period of at least three years as of the end of December 31,
2006 and as of the end of each six month period ending thereafter,

(b) on or before 10 days
following the effective date of Amendment No. 2, cause Pantwist, LLC to
enter into, and from and after such date, maintain (i) Hydrocarbon Hedge
Agreements covering not less than 50% of the “proved, developed and producing”
crude oil reserves attributable to the Twister Oil and Gas Properties for a
minimum period of at least three years as of the effective date of Amendment No. 2
and as of the end of each two fiscal quarter period ending thereafter, and at a
minimum floor of $60 per Bbl (or such other minimum floor as required by the
Required Lenders from time to time), and (ii) Hydrocarbon Hedge Agreements
covering not less than 50% of the “proved, developed and producing” natural gas
reserves attributable to the Twister Oil and Gas Properties for a minimum
period of at least three years as of the effective date of Amendment No. 2
and as of the end of each two fiscal quarter period ending thereafter, and with
a weighted average contract price of $7.60 per Mcf (or such other weighted
average contract price as required by the Required Lenders from time to time),
and

(c) notwithstanding any of
the foregoing, maintain Hydrocarbon Hedge Agreements covering no less than 50%
and no more than 80% of the production volumes attributable to “proved,
developed and producing” Proven Reserves of the Borrower’s and its Subsidiaries’
Oil and Gas Properties.

(q)           Section 6.02 of
the Credit Agreement is hereby amended by (i) replacing the period
appearing at the end of clause (i) thereof with a semicolon and (ii) adding
new clauses (j) and (k) to the end thereof as follows:

(j)            Debt Issuance
by the Borrower; provided that (i) such issuance, together with any Equity
Issuance of convertible, preferred stock in accordance with Section 6.22,
shall not exceed $60,000,000 in the aggregate; (ii) such Debt shall have (A) a
maturity date that is no earlier than November 28, 2009, (B) covenants
and restrictions that are no more restrictive than those set forth in this
Agreement and the other Loan Documents and which are, in any event,
satisfactory to the Administrative Agent, (C) no restriction on the
ability of the Borrower or any of its Subsidiaries to amend, modify or
otherwise supplement this Agreement or the other Loan Documents, (D) no
collateral or other security for such Debt, (E) no restriction on the
ability of the Borrower or any of its Subsidiaries to guarantee the Obligations
or pledge assets as collateral security for the Obligations, (F) a bullet
repayment and not provide for amortization (other than amortization resulting
from any mandatory prepayments required in respect of such Debt in connection
with the occurrence of an event of default under such Debt), (G) conversion
terms acceptable to the Administrative Agent, and (H) such other terms,
conditions and provisions that are satisfactory to the 

 8
 

 

Administrative Agent; (iii) such Debt shall be subordinated, in
right of payment and otherwise, to the payment of the Obligations and the
rights and remedies available to the Administrative Agent, the Lenders and the
Swap Counterparties hereunder or under any other Loan Document, in a manner,
and pursuant to documentation, satisfactory to the Administrative Agent in its
sole discretion, including without limitation, payment blockage provisions and
standstill periods of no less than 180 days; (iv) the Debt Issuance
Proceeds shall be applied, first to satisfy the outstanding Subordinated Debt
in full and second to prepay the Obligations as calculated under Section 2.05(f);
and (v) such Debt Issuance shall not otherwise cause the occurrence of a
Default or Event of Default after giving effect to the issuance of such Debt;
and

(k)          Debt consisting of
preferred Equity Interests of the Borrower; provided that such Equity Interests
are issued in compliance with Section 6.22.

(r)            Section 6.05 of the Credit Agreement is deleted in its entirety
and replaced with the following:

Section 6.05         Restricted Payments. The
Borrower shall not, nor shall it permit any of its Subsidiaries to, make any
Restricted Payments except that if no Default has occurred both before and
after giving effect to the making of such Restricted Payment, (a) the
Subsidiaries may make Restricted Payments to the Borrower, (b) the
Borrower may make Restricted Payments to officers, directors, consultants and
employees of the Borrower or any Guarantor in any form other than cash or other
assets of the Borrower, (c) the Borrower may make Restricted Payments to
officers, directors, consultants and employees of the Borrower or any Guarantor
in the form of cash in an aggregate amount not to exceed $1,000,000 per fiscal
year, (d) the Borrower may make Restricted Payments in respect of
preferred Equity Interests which were issued in compliance with Section 6.22,
and (e) the Borrower may make Restricted Payments in respect of Debt
Issuances which were issued in compliance with Section 6.02(j) to the
extent such payments would be permitted under the subordination terms in effect
in favor of the Obligations and covering such Debt Issuances.

(s)           Section 6.18 of
the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.18         Leverage Ratio.

(a)          Other than as provided in clause (b) below,
the Borrower shall not permit the Leverage Ratio at the end of each fiscal
quarter ending on or after March 31, 2007 to be greater than 5.00 to 1.00;
provided that, if the Subordinated Debt has been paid in full, then solely for
purposes of calculating Leverage Ratio under this clause (a), “consolidated
Debt” shall not include Debt outstanding under preferred Equity Interests
issued in compliance with Section 6.22.

(b)          If a Debt Issuance has occurred and
the Subordinated Debt has been paid in full, then the Borrower shall not permit
(i) the Leverage Ratio at the 

 9
 

 

end of the fiscal quarter ending
on March 31, 2007 to be greater than 7.50 to 1.00, (ii) the Leverage
Ratio at the end of the fiscal quarter ending June 30, 2007 to be greater
than 7.00 to 1.00 and (iii) the Leverage Ratio at the end of each fiscal
quarter ending on or after September 30, 2007 to be greater than 5.00 to
1.00; provided that, solely for purposes of calculating Leverage Ratio under
this clause (b), “consolidated Debt” shall not include Debt outstanding under
preferred Equity Interests, if any, issued in compliance with Section 6.22.

(t)            Section 6.19
of the Credit Agreement is hereby deleted in its entirety and replaced with the
following:

Section 6.19         Interest Coverage Ratio. The
Borrower (a) shall not permit the ratio of, as of the fiscal quarter
ending June 30, 2006, (i) the consolidated EBITDA of the Borrower for
the fiscal quarter period then ended multiplied by four, to (ii) the
consolidated Interest Expense of the Borrower for the fiscal quarter period
then ended multiplied by four, to be less than 1.25 to 1.00; (b) shall not
permit the ratio of, as of the fiscal quarter ending September 30, 2006, (i) the
consolidated EBITDA of the Borrower for the two fiscal quarter period then
ended multiplied by two, to (ii) the consolidated Interest Expense of the
Borrower for the two fiscal quarter period then ended multiplied by two, to be
less than 1.25 to 1.00; (c) shall not permit the ratio of, as of the
fiscal quarter ending December 31, 2006, (i) the consolidated EBITDA
of the Borrower for the three fiscal quarter period then ended multiplied by
4/3, to (ii) the consolidated Interest Expense of the Borrower for the
three fiscal quarter period then ended multiplied by 4/3, to be less than 1.25
to 1.00; (d) shall not permit the ratio of, as of the fiscal quarter
ending March 31, 2007, (i) the consolidated EBITDA of the Borrower
calculated for the four fiscal quarters then ended, to (ii) the
consolidated Interest Expense of the Borrower for the four fiscal quarters then
ended, to be less than 1.50 to 1.00; and (e) shall not permit the ratio
of, as of the end of any fiscal quarter ending on or after June 30, 2007, (i) the
consolidated EBITDA of the Borrower calculated for the four fiscal quarters
then ended, to (ii) the consolidated Interest Expense of the Borrower for
the four fiscal quarters then ended, to be less than 2.00 to 1.00.

(u)           Article VI to
the Credit Agreement is hereby amended by adding a new Section 6.22 to the
end thereof as follows:

Section 6.22         Equity Issuance. The Borrower
shall not, nor shall it permit any of its Subsidiaries to, issue any preferred,
convertible equity securities or other Equity Interests unless (a) the
maturity thereof shall not be earlier than November 28, 2009, (b) the
other terms thereof, including any conversion terms, are satisfactory to the
Administrative Agent, (c) the Equity Issuance Proceeds thereof are
applied, first to satisfy the outstanding Subordinated Debt in full and second
to prepay the Obligations as calculated under Section 2.05(g), and (d) such
issuance of preferred or convertible Equity Interests, together with any Debt
Issuance permitted under Section 6.02(j), does not exceed $60,000,000 in
the aggregate.

 10
 

 

(v)           Section 7.01 of
the Credit Agreement is hereby amended by replacing clause (c)(i) in its
entirety with the following:

 (i) perform or observe any covenant
contained in Section 5.02(a), Section 5.03, Section 5.06(e), Section 5.09,
Section 5.12, or Article VI of this Agreement or

(w)          Section 7.01 of
the Credit Agreement is hereby further amended by adding a new clause (r) to
the end thereof as follows:

(r)           A Debt Issuance or an Equity Issuance has occurred and the
Debt Issuance Proceeds or the Equity Issuance Proceeds thereof is less than
$45,000,000.

(x)            Schedule I-Pricing Grid, Schedule
4.07, Exhibit B — Compliance Certificate, and Exhibit F- Notice of
Borrowing which are attached to the Credit Agreement are hereby replaced in
their entirety with the corresponding Schedule
I-Pricing Grid, Schedule 4.07, Exhibit B — Compliance Certificate, and Exhibit F-
Notice of Borrowing attached to this Agreement.

Section 18.            Consent
to Amendment Terms of the Subordinated Debt. As required under Section 6.20 of the
Credit Agreement, the Lenders hereby consent to the terms of the Third
Amendment to Subordinated Credit Agreement dated as of June 30, 2006, an
execution version of which is attached hereto as Exhibit A.

Section 19.            Borrower Representations and
Warranties.
The Borrower represents and
warrants that: (a) after giving effect to this Agreement, the
representations and warranties contained in the Credit Agreement and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or
warranty expressly relates solely to an earlier date, in which case such
representation or warranty is true and correct in all material respects as of
such earlier date; (b) after giving effect to this Agreement, no Default
has occurred and is continuing; (c) the
execution, delivery and performance of this Agreement are within the corporate
power and authority of the Borrower and have been duly authorized by
appropriate corporate and governing action and proceedings; (d) this
Agreement constitutes the legal, valid, and binding obligation of the Borrower
enforceable in accordance with its terms, except as limited by applicable
bankruptcy, insolvency, reorganization, moratorium, or similar laws affecting
the rights of creditors generally and general principles of equity; (e) there
are no governmental or other third party consents, licenses and approvals
required in connection with the execution, delivery, performance, validity and
enforceability of this Agreement; and (f) the Liens under the Security
Instruments are valid and subsisting and secure Borrower’s obligations under
the Loan Documents.

Section 20.            Guarantors Representations
and Warranties. Each
Guarantor represents and warrants that: (a) after giving effect to this
Agreement, the representations and warranties contained in the Guaranty and the
representations and warranties contained in the other Loan Documents are true
and correct in all material respects on and as of the Effective Date as if made
on as and as of such date except to the extent that any such representation or 

 11
 

 

warranty expressly relates
solely to an earlier date, in which case such representation or warranty is
true and correct in all material respects as of such earlier date; (b) after
giving effect to this Agreement, no Default has occurred and is continuing; (c) the
execution, delivery and performance of this Agreement are within the corporate,
limited liability company, or partnership power and authority of such Guarantor
and have been duly authorized by appropriate corporate, limited liability
company, or partnership action and proceedings; (d) this Agreement
constitutes the legal, valid, and binding obligation of such Guarantor
enforceable in accordance with its terms, except as limited by applicable
bankruptcy, insolvency, reorganization, moratorium, or similar laws affecting
the rights of creditors generally and general principles of equity; (e) there
are no governmental or other third party consents, licenses and approvals
required in connection with the execution, delivery, performance, validity and
enforceability of this Agreement; (f) it has no defenses to the
enforcement of the Guaranty; and (g) the Liens under the Security
Instruments are valid and subsisting and secure such Guarantor’s and the
Borrower’s obligations under the Loan Documents.

Section 21.            Conditions to Effectiveness. This Agreement and the amendments to the
Credit Agreement provided herein shall become effective on the Effective Date
and enforceable against the parties hereto upon the occurrence of the following
conditions precedent:

(a)           The Administrative Agent shall have
received multiple original counterparts, as requested by the Administrative
Agent, of this Agreement duly and validly executed and delivered by duly
authorized officers of the Borrower, the Guarantors, the Administrative Agent,
and the Lenders.

(b)           The representations
and warranties in this Agreement shall be true and correct in all material
respects.

(c)           The Borrower shall have paid (i) all fees and expenses of the Administrative
Agent’s outside legal counsel and other consultants pursuant to all invoices
presented for payment on or prior to the Effective Date, and (ii) an
amendment fee of $200,000 to the Administrative Agent for the account of the
Lenders.

Section 22.            Acknowledgments and
Agreements.

(d)           The Borrower acknowledges that on the
date hereof all Obligations are payable without defense, offset, counterclaim
or recoupment.

(e)           The Administrative
Agent and the Lenders hereby expressly reserve all of their rights, remedies,
and claims under the Loan Documents. Nothing in this Agreement shall constitute
a waiver or relinquishment of (i) any Default or Event of Default under
any of the Loan Documents, (ii) any of the agreements, terms or conditions
contained in any of the Loan Documents, (iii) any rights or remedies of
the Administrative Agent or any Lender with respect to the Loan Documents, or (iv) the
rights of the Administrative Agent or any Lender to collect the full amounts
owing to them under the Loan Documents.

(f)            Each of the
Borrower, the Guarantors, Administrative Agent, and Lenders does hereby adopt,
ratify, and confirm the Credit Agreement, as amended hereby, and acknowledges
and agrees that the Credit Agreement, as amended hereby, is and remains in full

 12
 

 

force
and effect, and the Borrower and the Guarantors acknowledge and agree that
their respective liabilities and obligations under the Credit Agreement, as
amended hereby, and the Guaranty, are not impaired in any respect by this
Agreement.

(g)           From and after the
Effective Date, all references to the Credit Agreement and the Loan Documents
shall mean such Credit Agreement and such Loan Documents as amended by this
Agreement.

(h)           This Agreement is a
Loan Document for the purposes of the provisions of the other Loan Documents. Without
limiting the foregoing, any breach of representations, warranties, and
covenants under this Agreement shall be a Default or Event of Default, as
applicable, under the Credit Agreement.

Section 23.            Reaffirmation of the
Guaranty. Each Guarantor
hereby ratifies, confirms, acknowledges and agrees that its obligations under
the Guaranty are in full force and effect and that such Guarantor continues to
unconditionally and irrevocably guarantee the full and punctual payment, when
due, whether at stated maturity or earlier by acceleration or otherwise, all of
the Guaranteed Obligations (as defined in the Guaranty), as such Guaranteed
Obligations may have been amended by this Agreement, and its execution and
delivery of this Agreement does not indicate or establish an approval or
consent requirement by such Guarantor under the Guaranty in connection with the
execution and delivery of amendments, consents or waivers to the Credit
Agreement, the Notes or any of the other Loan Documents.

Section 24.            Counterparts.
This Agreement may be
signed in any number of counterparts, each of which shall be an original and
all of which, taken together, constitute a single instrument. This Agreement
may be executed by facsimile signature and all such signatures shall be
effective as originals.

Section 25.            Successors
and Assigns. This
Agreement shall be binding upon and inure to the benefit of the parties hereto
and their respective successors and assigns permitted pursuant to the Credit
Agreement.

Section 26.            Invalidity.
In the event that any
one or more of the provisions contained in this Agreement shall for any reason
be held invalid, illegal or unenforceable in any respect, such invalidity,
illegality or unenforceability shall not affect any other provision of this
Agreement.

Section 27.            Governing
Law. This
Agreement shall be deemed to be a contract made under and shall be governed by
and construed in accordance with the laws of the State of Texas.

Section 28.            Entire Agreement. THIS
AGREEMENT, THE CREDIT AGREEMENT AS AMENDED BY THIS AGREEMENT, THE NOTES, AND
THE OTHER LOAN DOCUMENTS CONSTITUTE THE ENTIRE UNDERSTANDING AMONG THE PARTIES
HERETO WITH RESPECT TO THE SUBJECT MATTER HEREOF AND SUPERSEDE ANY PRIOR
AGREEMENTS, WRITTEN OR ORAL, WITH RESPECT THERETO.

THERE
ARE NO UNWRITTEN ORAL AGREEMENTS AMONG THE PARTIES.

 13
 

 

[SIGNATURES
BEGIN ON NEXT PAGE]

 

 14

 

EXECUTED effective
as of the date first above written.

	
  BORROWER:

  	
  CANO PETROLEUM, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  Chief Executive Officer

  
	
   

  	
   

  	
   

  
	
  GUARANTORS:

  	
  SQUARE ONE ENERGY, INC.

  
	
   

  	
  LADDER COMPANIES, INC.

  
	
   

  	
  W.O. ENERGY OF NEVADA, INC.

  
	
   

  	
  WO ENERGY, INC.

  
	
   

  	
  PANTWIST, LLC

  
	
   

  	
   

  	
   

  
	
   

  	
  Each by:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. OPERATING COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
	
   

  	
   

  	
   

  
	
   

  	
  W.O. PRODUCTION COMPANY, LTD.

  
	
   

  	
  By: WO Energy, Inc., its general partner

  
	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  S. Jeffrey Johnson

  
	
   

  	
   

  	
  President

  
				

 

 

 

	
  ADMINISTRATIVE AGENT/

  ISSUING LENDER/LENDER:

  	
  

  UNION BANK OF CALIFORNIA, N.A.,

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  Kimberly Coil

  
	
   

  	
   

  	
  Vice President

  

 

 

 

	
  

  	
  NATEXIS BANQUES POPULAIRES

  
	
   

  	
  as a Lender

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
  Name:

  	
   

  
	
   

  	
  Title:

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
  Name:

  	
   

  
	
   

  	
  Title:

  	
   

  

 

 

Exhibit A

 

SCHEDULE I

PRICING GRID

Applicable
Margins

	
  Utilization Level*

  	
   

  	
  Base Rate

  Advances

  	
   

  	
  Eurodollar Rate

  Advances

  	
   

  	
  Commitment Fee

  	
   

  
	
  Level I

  	
   

  	
  1.00

  	
  %

  	
  2.50

  	
  %

  	
  0.50

  	
  %

  
	
  Level II

  	
   

  	
  1.25

  	
  %

  	
  2.75

  	
  %

  	
  0.375

  	
  %

  
	
  Level III

  	
   

  	
  1.50

  	
  %

  	
  3.00

  	
  %

  	
  0.375

  	
  %

  
	
  Level IV

  	
   

  	
  1.75

  	
  %

  	
  3.25

  	
  %

  	
  0.375

  	
  %

  

*                    Utilization
Levels are described below and are determined in accordance with the definition
of “Utilization Level”.

1.                  Level I: If the Utilization Level is less
than 50%.

2.                  Level II: If the Utilization Level is greater
than or equal to 50% but less than 75%.

3.                  Level III: If the Utilization Level is
greater than or equal to 75% but less than 90%.

4.                  Level IV: If the Utilization Level is
greater than or equal to 90%.

 

EXHIBIT
B

FORM OF
COMPLIANCE CERTIFICATE

FOR THE PERIOD FROM               ,
200     TO                 ,
200    

This certificate dated as of                       
      ,           
is prepared pursuant to the Subordinated Credit Agreement dated as of November 29,
2005 (as amended, supplemented or otherwise modified from time to time, the “Credit
Agreement”) among CANO PETROLEUM, INC., a Delaware corporation (“Borrower”),
the lenders party thereto (the “Lenders”), and ENERGY COMPONENTS SPC EEP ENERGY
EXPLORATION AND PRODUCTION SEGREGATED PORTFOLIO, as administrative agent for
such Lenders (in such capacity, the “Administrative Agent”). Unless
otherwise defined in this certificate, capitalized terms that are defined in
the Credit Agreement shall have the meanings assigned to them by the Credit
Agreement.

The
undersigned hereby certifies that:

(a)                                  all of the representations and warranties
made by the Borrower in the Credit Agreement and the other Loan Documents are
true and correct in all material respects as if made on this date, except to
the extent that any such representation or warranty expressly relates solely to
an earlier date, in which case it shall have been true and correct in all
material respects as of such earlier date;

[(b)     that no Default or Event of Default has
occurred and is continuing; and]

[(b)     the following Default[s] or Event[s] of
Default exist as of the date hereof or have occurred since the date of the
Borrower’s previous certification to the Administrative Agent, if any, and the
actions set forth below have been or are being taken to remedy such
circumstances:

                                                                        ;
and]

(c) that
as of the last day of the previous quarter the following statements, amounts,
and calculations were true and correct:

I.                                         Current Ratios—Section 6.17.

	
  (a)  consolidated
  current assets(1)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (b)  consolidated
  current liabilities(2)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Current ratio =
  (a) to (b) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Minimum current ratio
  not less than:

  	
   

  	
  1.00
  to 1.00

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES     NO

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (c)  Total
  Reserve Value

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  

 

(1)             “current assets” shall include
the aggregate Unused Commitment Amounts of the Lenders, but shall exclude (A)
any cash deposited with or at the request of a counterparty to any Hedge
Contract or any other similar hedge arrangement and (B) any assets representing
a valuation account arising from the application of SFAS 133 and 143.

(2)             “current liabilities” shall
exclude, as of the date of calculation, the current portion of long-term Debt
existing under the Credit Agreement and any liabilities representing a
valuation account arising from the application of SFAS 133 and 143.

 

 

	
  (d)  consolidated
  Debt

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Current
  ratio = (c) to (d) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Minimum
  current ratio not less than:

  	
   

  	
  1.50 to 1.00

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES     NO

  	
   

  

 

II.            Leverage Ratio—Section 6.18.

	
  (a)  consolidated
  Debt

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (b)  consolidated
  EBITDA(3) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (i) +
  [(ii) + (iii) + (iv)](4) - (v) =

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (i)  Consolidated
  Net Income

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (ii)  consolidated
  Interest Expense

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (iii)  taxes

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (iv)  depreciation,
  amortization, depletion & other non-cash items(5)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (v)  all
  non-cash items of income included in determining Consolidated Net Income(6)

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Leverage Ratio =
  (a) to (b) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Maximum Leverage Ratio:

  	
   

  	
  5.00
  to 1.00(7)

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES     NO

  	
   

  

(3)             EBITDA
shall be measured by the four fiscal quarter period then ended.  Furthermore, (a) for the fiscal quarter
ending March 31, 2006, EBITDA shall be calculated using EBITDA for the fiscal
quarter period then ended multiplied by 4; 
(b) for the fiscal quarter ending June 30, 2006, EBITDA shall be
calculated using EBITDA for the two fiscal quarter period then ended multiplied
by 2; (c) for the fiscal quarter ending September 30, 2006, EBITDA shall be
calculated using EBITDA for the three fiscal quarter period then ended
multiplied by 4/3 and (d) for fiscal quarters ending on or after December 31,
2006, EBITDA shall be calculated using EBITDA for the four fiscal quarters then
ended.

(4)             Items
(ii) – (iv) shall be included to the extent deducted in determining Consolidated
Net Income.

(5)             Other
non-cash items should include any provisions for the reduction in the carrying
value of assets recorded in accordance with GAAP and including non-cash charges
resulting from the requirements of SFAS 133 or 143.

(6)             Non-cash
items of income should include any items resulting from the requirements of
SFAS 133 or 143.

(7)             For
all fiscal quarters ending on or after March 31, 2007.

 

 

III.           Interest
Coverage Ratio—Section 6.19.

	
  (a)  consolidated
  EBITDA = See II(b) above =

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  (b)  consolidated
  Interest Expense(8) =

  	
   

  	
  $

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Interest Coverage Ratio
  = (a) to (b) =

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
  Minimum Interest
  Coverage Ratio =

  	
   

  	
  [1.25
  to 1.00][1.50 to 1.00]

  	
   

  
	
   

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
  [2.00
  to 1.00](9)

  	
   

  
	
  COMPLIANCE?

  	
   

  	
  YES     NO

  	
   

  

(8)             (a)
for the fiscal quarter ending March 31, 2006, Interest Expense shall be
calculated using Interest Expense for the fiscal quarter period then ended
multiplied by 4; (b) for the fiscal quarter ending June 30, 2006, Interest
Expense shall be calculated using Interest Expense for the two fiscal quarter
period then ended multiplied by 2; (c) for the fiscal quarter ending September
30, 2006, Interest Expense shall be calculated using Interest Expense for the
three fiscal quarter period then ended multiplied by 4/3 and (d) for fiscal
quarters ending on or after December 31, 2006, Interest Expense shall be
calculated using Interest Expense for the four fiscal quarters then ended.

(9)             Use
(a) 1.25 to 1.00 for fiscal quarters ending on or after June 30, 2006 but prior
to March 31, 2007, (b) 1.50 to 1.00 for fiscal quarter ending March 31, 2007,
and (c) 2.00 to 1.00 for fiscal quarters ending on or after June 30, 2007.

IN WITNESS THEREOF, I have hereto signed my name to
this Compliance Certificate as of                                   ,
20        .

	
  

  	
  CANO PETROLEUM, INC., a Delaware 

  corporation

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
  Name:

  	
   

  
	
   

  	
  Title:

  	
   

  

 

 

Schedule 4.07

Litigation

On March 23, 2006,
the following lawsuit was filed in the 100th Judicial District Court in Carson County,
Texas; Cause No. 9840, The Tom L. and Anne Burnett Trust, by Anne Burnett
Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, III and Ed
Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and Burnett Ranches,
Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O.
Operating Company, Ltd, and W.O. Energy, Inc.

On April 28, 2006,
the following lawsuit was filed in the 31st Judicial District Court of Roberts County,
Texas, Case No. 1922, Robert and Glenda Adcock, et al. v. Cano Petroleum, Inc.,
W.O. Energy of Nevada, Inc.; W. O. Operating Company, Ltd, and W.O. Energy, Inc.

On April 10, 2006,
the following lawsuit was filed in the 31st Judicial District Court of Roberts County,
Texas, Case No. 1920, Joseph Craig Hutchison and Judy Hutchison v. Cano
Petroleum, Inc., W.O. Energy of Nevada, Inc.; W. O. Operating
Company, Ltd, and W.O. Energy, Inc.

On May 1, 2006, the
following lawsuit was filed in the 31st Judicial District Court of Roberts County,
Texas, Case No. 1923, Chisum Family Partnership, Ltd. v. Cano Petroleum, Inc.,
W.O. Energy of Nevada, Inc.; W. O. Operating Company, Ltd, and W.O. Energy, Inc.

The plaintiffs in the
above actions claim that the electrical wiring and equipment of Cano Petroleum, Inc.
or certain of its subsidiaries relating to its oil and gas operations started a
wildfire that began on March 12, 2006 in Carson County, Texas. The
plaintiffs (i) allege negligence and gross negligence and (ii) seek
undisclosed damages, including, but not limited to, damages for damage to their
land and livestock, certain expenses related to fighting the fire and certain
remedial expenses. In addition, certain plaintiffs seek (i) termination of
certain oil and gas leases, (ii) reimbursement for their attorney’s fees
and (iii) exemplary damages.

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