UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-QSB

(Mark One)

For the transition period from                 to               

Commission file number                

CANO PETROLEUM, INC.

(Exact name of small business issuer as specified in its charter)

The Oil & Gas Commerce Building
309 West 7^th Street, Suite 1600

Fort Worth, TX 76102

(Address of principal executive offices)

(817) 698-0900

(Issuer’s telephone number)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý      No o

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS

Check whether the registrant filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court.  Yes o      No o

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:  20,352,757 shares of common stock, $.0001 par value per share, as of May 13, 2005.

Transitional Small Business Disclosure Format (Check one): Yes o      No ý

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

CANO PETROLEUM, INC.

CONSOLIDATED BALANCE SHEET

(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS

1.              BASIS OF PRESENTATION

The interim consolidated financial statements of Cano Petroleum, Inc. are unaudited and contain all adjustments (consisting primarily of normal recurring accruals) necessary for a fair statement of the results for the interim periods presented.  Results for interim periods are not necessarily indicative of results to be expected for a full year or for previously reported periods due in part to the volatility in prices for crude oil and natural gas, the timing of acquisitions, interruption in production and the success of drilling activity.  You should read these consolidated interim financial statements in conjunction with the audited consolidated financial statements and notes thereto included in Cano’s Form 10-KSB dated June 30, 2004.

2.              ACQUISITIONS

Ladder Company Oil and Gas Properties - On July 2, 2004, we acquired all of the outstanding common stock of the Ladder Companies, Inc., a Delaware corporation, for approximately $2.2 million, after purchase price adjustments.  The Ladder Companies comprise two companies — Ladder Energy Company, a Delaware corporation, and Tri-Flow, Inc., an Oklahoma corporation.  The Ladder Companies are engaged in oil and gas exploration and production activities.  The acquisition was effective on May 1, 2004, and net operating income from that date through closing was applied to the purchase price.

Nowata Oil Properties — On September 14, 2004, we acquired oil and gas producing leases from the Nowata Oil Properties LLC for approximately $2.6 million.  The leases are located in Nowata County, Oklahoma.  The effective date of the purchase is September 1, 2004.

Square One Energy — On March 29, 2005, we completed the acquisition of Square One Energy, Inc. (“Square One”).  The value of the consideration we paid for Square One was $7.5 million, consisting of $4 million in cash and 888,888 shares of our common stock, which was valued at $3.96 per share.

The Ladder, Nowata and Square One acquisitions were recorded based on the purchase method of accounting.  The purchase prices were allocated to the acquired assets and assumed liabilities based on their fair values.  The calculation of each purchase price and allocation to assets is as follows:

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The fair value assigned to the oil and gas properties is based on management’s valuation of the properties, which was derived in part by reference to reserve reports prepared by an independent petroleum engineering firm.  Based on the engineer’s reports and Cano’s internal analyses, we believe the value assigned to these properties is reasonably supported.  Regarding the valuation of Square One, the process of determining the fair value of assets and liabilities is underway, and the final results will not be completed until certain information about pre-acquisition contingencies is assessed.

Pro Forma Financial Information

The following condensed pro forma information gives effect to the acquisitions as if they had occurred on July 1, 2004 and 2003, respectively.  The pro forma information has been included in the Notes as required by generally accepted accounting principles and is provided for comparison purposes only.  The pro forma financial information is not necessarily indicative of the financial results that would have occurred had the business combinations been effective on the dates indicated and should not be viewed as indicative of operations in the future.

Cano Petroleum, Inc.

Pro Forma Information

3.              PREFERRED STOCK

                        Financings

For the nine months ended March 31, 2005, we issued $5.35 million of Series C Convertible Preferred Stock (5,350 shares at $1,000 per share).  This increased our total issuances of preferred stock to $8.75 million (net proceeds of $8.5 million).

The total issuances consisted of $2 million of Series B Convertible Preferred Stock and $6.75 million of Series C Convertible Preferred Stock.  These were non-voting shares issued at a price of $1,000 per share.  The holders of the Series B and Series C Preferred Stock were not entitled to receive any dividends.

Conversion to Common

During March 2005, the preferred stockholders elected to convert their preferred shares to common shares.  Each share of Series B and Series C Convertible Preferred Stock was converted by the holder into shares of our common stock at a price of $3.00 and $3.75 per share, respectively.  The conversion is summarized in the following table:

As of March 31, 2005, there were no outstanding issuances of preferred stock.  Our common stock is the only class of stock outstanding.

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Beneficial Conversion Feature Related to our Series C Preferred Stock

On the dates of certain issuances of our Series C Preferred Stock, the quoted market price of our common stock was higher than the conversion price of our Series C Preferred Stock of $3.75 per share, resulting in a beneficial conversion feature.   The value of the beneficial conversion feature was a discount to preferred stock and a charge to earnings available to common stockholders, analogous to a preferred dividend.  As a direct result, we recognized a $416,534 increase in accumulated deficit with a corresponding increase in additional paid-in capital.  Because the Series C Preferred Stock was convertible into common stock on the date of issuance, the discount was immediately recognized as a charge to accumulated deficit, and therefore, there was no impact to Series C Preferred Stock on the balance sheet.

4.     COMMON STOCK FINANCINGS

On March 18, 2005, we entered into agreements to sell 1,350,000 shares of common stock to two accredited institutional investors at a price of $3.75 per share.  The transactions closed on March 24, 2005.  We received gross proceeds of $5.1 million from the sale of these common shares (net proceeds of $4.8 million).

The amount of common shares issued and outstanding is summarized as follows:

5.              RELATED PARTY TRANSACTIONS

On August 16, 2004, we agreed to purchase an additional 10% revenue interest in the Davenport field from Cano Energy Corporation (“CEC”).  This increased our revenue interest in the Davenport field to 65%.  In consideration for the additional 10% revenue interest, we agreed to pay $667,000 cash to CEC.  The final payment installment was made in October 2004.  Our CEO, S. Jeffrey Johnson, is a principal shareholder of Cano Energy Corporation.

As of March 31, 2005, there were no outstanding balances between Cano and CEC.

On December 16, 2004, we issued stock options for 50,000 shares of our common stock to Gerald Haddock, who currently serves on our board of directors.  The exercise price is $4 per option share.  The options cannot be exercised for a six month period, referred to as the option period.  After the option period, the options will expire in ten years.  In accordance with the provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, we have recorded a charge to general and administrative expenses of $78,666 for the estimated fair value of the options.

6.              RESTRICTED CASH

As discussed in Cano’s Form 10-KSB dated June 30, 2004, pursuant to the terms of the Merger Agreement, funds totaling $866,339 were placed in escrow and dedicated to improvements and drilling in the Davenport field.   We have conducted drilling activities and implemented improvements in the Davenport field during the 2005 fiscal year, which were funded by this escrowed amount.  At March 31, 2005, the escrow balance was used in its entirety, and accordingly, no longer appears in the Consolidated Balance Sheet.

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7.              ASSET RETIREMENT OBLIGATION

Our financial statements reflect the provisions of Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations.  Our asset retirement obligation (“ARO”) primarily represents the estimated present value of the amount we will incur to plug, abandon and remediate our producing properties at the end of their productive lives, in accordance with applicable state laws.  We determine our ARO by calculating the present value of estimated cash flows related to the liability.  At March 31, 2005, our liability for ARO was $598,580, of which $581,397 is considered long term.  Our asset retirement obligations are recorded as current or non-current liabilities based on the estimated timing of the anticipated cash flows. For the nine months ended March 31, 2005, we have recognized accretion expense of $16,444.

The following table describes the changes in our asset retirement obligations for the nine months ended March 31, 2005:

8.              DEFERRED COMPENSATION

As discussed in our Form 10-KSB dated June 30, 2004, pursuant to the terms of the Merger Agreement, eight individuals (seven of whom are now employed by us and one who is a member of our board of directors) were issued 5,165,000 shares of common stock.  These shares were placed in escrow.  The shares will vest to the individuals based on a combination of continued employment (“compensation shares”) and achieving certain performance goals (“performance shares”) during the period ending June 30, 2006.  The compensation shares amounted to 2,659,975 shares and the performance shares amounted to 2,505,025 shares.  Any shares that are not released from escrow will be returned to Treasury Stock.  We have accounted for these shares in accordance with the provisions of SFAS Nos. 123 and 148.  At the merger date, we recognized $2,324,250 of “Deferred Compensation” and “Additional Paid-in Capital” in the Consolidated Balance Sheet.  The shares were recorded based on the quoted market price at the time of the transaction and are being amortized to expense over the periods earned.  At March 31, 2005, the balance of Deferred Compensation was $886,121, net of amortization expense.

9.              NET LOSS PER COMMON SHARE

Basic net income (loss) per common share is computed by dividing the net income attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period.  Diluted net income (loss) per common share is computed in the same manner, but also considers the effect of the stock options.  The stock options are not considered for the three and nine months ended March 31, 2005 as their effects would be anti-dilutive.

The weighted average shares used in the basic loss per common share computations for the three months ended March 31, 2005 and 2004 were 11,204,155 shares and 6,982,204 shares, respectively.  The weighted average shares used in the basic loss per common share computations for the nine

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months ended March 31, 2005 and 2004 were 10,722,854 and 6,982,204, respectively.  The shares at March 31, 2005 exclude 5,165,000 contingently issuable shares as discussed in Note 8.

10.       COMMITMENTS AND CONTINGENCIES

Litigation

Occasionally, we are involved in various lawsuits and certain governmental proceedings arising in the ordinary course of business.  Our management and legal counsel do not believe that the ultimate resolution of such matters, will have a material effect on our financial position or results of operations.

Other

To date, our expenditures to comply with environmental or safety regulations have not been significant and are not expected to be significant in the future. However, new regulations, enforcement policies, claims for damages or other events could result in significant future costs.

Item 2.  Management’s Discussion and Analysis / Plan of Operation.

                On May 5, 2005, we began trading our common stock on the American Stock Exchange under the symbol “CFW.”  Previously, we were trading our common stock on the Over-The-Counter Bulletin Board under the symbol “CAOP.”

Forward-Looking Statements

The information in this report on Form 10-QSB contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves provided they identify these statements as forward looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact made in this report are forward looking. In particular, the statements herein regarding industry prospects and future results of operations or financial position are forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Our actual results may differ significantly from management’s expectations as a result of many factors, including, but not limited to, the volatility in prices for crude oil and natural gas, the timing of acquisitions, interruption in production and the success of drilling operations and secondary recovery efforts.

The following discussion and analysis should be read in conjunction with the consolidated financial statements of Cano Petroleum, Inc. and subsidiaries and notes thereto, included herewith. This discussion should not be construed to imply that the results discussed herein will necessarily continue into the future, or that any conclusion reached herein will necessarily be indicative of actual operating results in the future. Such discussion represents only the best present assessment of management.

Plan of Operation

Overall Strategy

We are a growing independent oil and gas company that intends to actively pursue enhanced oil recovery techniques to increase production and reserves at our existing properties and future acquisitions.  Our primary focus is crude oil and our target acquisitions are onshore U.S. properties.  Our focus on domestic, mature oil fields eliminates exploration risks and uncertainties of international sources.  We use waterflooding and enhanced oil recovery techniques, such as Alkaline-Surfactant-Polymer (ASP) technology.

We believe significant opportunities exist primarily because the major energy companies and large independents continue to focus their attention and resources toward the discovery and development of large fields.  In the past several years, the major companies have been divesting themselves of their mature

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oilfields.  Also, the recent economics of the oil and gas market have improved as prices have risen substantially.  These conditions provide ample opportunities for smaller independent companies to acquire and exploit mature U.S. fields.  We expect that there will be increased competition for such properties in the future.

We will continue to target potential acquisition candidates in a disciplined manner.  By adhering to our disciplined approach, we expect to continue to find attractive economic acquisition and development opportunities.

Our competitive advantage is our in-house expertise and low internal overhead.  We employ independent engineers and geologists to aid in evaluating the economic merits of drilling plans and potential acquisitions.  We believe that the incremental cost of hiring independent engineering firms justifies the expense because they provide a check and balance on our acquisition and development plans.  Further, employing third party experts on a case-by-case basis enables us to maintain low operating expenses and adhere to our commitment to keep fixed costs low.

Liquidity and Capital Resources

We intend to finance future acquisitions of oil and gas properties, field development projects and operating activities with a combination of issuances of equity, access to capital markets, and cash flow from operations.  We cannot guarantee that any additional equity financing will be available in sufficient amounts or on acceptable terms when needed.  If such financing is not available in sufficient amounts or on acceptable terms, our results of operations and financial condition may be adversely affected.  In addition, equity financing may result in dilution to existing stockholders and may involve securities that have rights, preferences, or privileges that are senior to our common stock.

Financing and Investing Activities

As discussed in Note 3 to the financial statements, as of March 31, 2005, we have issued preferred stock totaling $8.75 million (net proceeds of $8.5 million), of which $5.35 million was issued during the past nine months.   Also, as discussed in Note 4, we received net proceeds of $4.8 million from the issuance of 1,350,000 shares of common stock during March 2005.

During March 2005, the preferred stockholders elected to convert their preferred shares to common shares.  As discussed in Note 3, the Series B and Series C Convertible Preferred Stock was converted into shares of our common stock at a price of $3.00 and $3.75 per share, respectively.  The total converted shares amounted to 2,466,665 common shares.  As of March 31, 2005, there were no outstanding issuances of preferred stock.  Our common stock is the only class of stock outstanding.

The proceeds from our stock issuances were our primary source to fund the Davenport Merger, as discussed in our Form 10-KSB dated June 30, 2004, and the following acquisitions and development activities during the nine months ended March 31, 2005:

•                Acquisition of the Nowata Oil Properties LLC for $2.6 million (Note 2).

•                  Acquisition of the Ladder Companies, Inc. for $2.2 million (Note 2).  For operational purposes, we refer to Ladder as the Rich Valley field.

•                  Acquisition of the Square One Energy, Inc. valued at $7.5 million (Note 2), consisting of $4 million of cash and issuing 888,888 common shares.  For operational purposes, we refer to Square One as the Desdemona field.

•                  Purchase of an additional 10% revenue interest in the Davenport field for $0.7 million (Note 5).

•                  Capital expenditures of $1.9 million, consisting primarily of drilling two wells in the Davenport field, and implementation of developmental activities and environmental safeguards.

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Based on reserve reports prepared by independent petroleum engineers dated January 1, 2005, our total reserves are summarized as follows:

Energy lenders typically loan to oil and gas companies based on the value of the proved producing reserves, defined as reserves that can be reasonably expected to be recovered from existing wells with existing equipment and operating methods from known reservoirs under existing economic and operating conditions.  We intend to seek a debt facility secured by our proved producing reserves to provide a source of cash to fund our operating activities and acquisitions.  Also, we will continue to consider issuances of equity as a potential option to provide cash to fund our operating activities and acquisitions.

Capital Spending Plan for 2005

In addition to potential future acquisitions, our capital spending plan for the remainder of 2005 is to implement developmental projects at our existing fields to increase reserves and production.  We project this cost to be approximately $3.6 million, and to be spent to develop the following fields:

Desdemona Field.  This was the primary asset of our Square One acquisition discussed in Note 2, consisting of 10,300 acres.  This field has not been previously waterflooded.  We plan to begin pilot waterflood operations in mid-2005 and expect an initial response in nine to twelve months.  If the pilot waterfloods are successful, we intend to begin expanding the waterflood to the entire field in 2006.  This field also has mineral rights to the Barnett Shale.  We intend to sell these land rights and focus on our core expertise — secondary and enhanced oil recovery.

Nowata Field.  This field is currently being waterflooded.  We intend to increase production and reserves by applying a chemical treatment known as such as Alkaline-Surfactant-Polymer (ASP) technology.  We are continuing to optimize the ASP chemistry in the labroatory and intend to begin implementing an ASP pilot at Nowata later this year.

Davenport Field.  This field is currently being waterflooded.  We intend to evaluate this field for ASP technology.  This evaluation, coupled with the knowledge gained from the Nowata ASP pilot, is expected to enhance its value as an ASP candidate.

Rich Valley Field.  We intend to drill one development well and conduct an evaluation for waterflood potential.

Operating Activities

For the nine months ended March 31, 2005, net cash used in operating activities was $558,722.  We are seeking to improve cash flow from operating activities through operational improvements at our existing properties and future acquisitions.  The increased cash flow from field operations could be offset, in part, by increased general and administrative costs to support our expanding operations.

Results of Operations

The table below summarizes our results of operations through March 31, 2005.

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As shown above, we had a net loss before certain accounting charges of $343,842 and $808,622, respectively, for the three and nine month periods ended March 31, 2005.  Since our acquisitions are mature fields, our initial focus is to evaluate the existing operations and make the necessary operational improvements to improve operating efficiency.  It generally requires six to twelve months to fully analyze the acquired field and spend the necessary funds to improve the field operations to meet our operational standards.  The net loss that we have experienced for the nine months ended March 31, 2005, is a direct result of spending the necessary funds to improve the operational efficiency of our field facilities and to fund start-up costs we incurred to fund our support services.  We expect these expenditures should lead to increased operational efficiency and reduced operating expenses in future periods.

Operating Revenues

The table below summarizes our operating revenues through March 31, 2005.

We expect future increases to sales through capital expenditures as previously discussed in “Plan of Operation - Capital Spending Plan for 2005.”

Operating Expenses

For the three and nine month periods ended March 31, 2005, our total operating expenses were $2,238,637 and $5,940,880, respectively.  Our operating expenses consist primarily of lease operating expenses, general and administrative, depletion and depreciation, and deferred compensation expense, as discussed in Note 8 to the financial statements.

Our lease operating expenses (“LOE”) consist of costs of producing crude oil and natural gas such as labor, supplies, repairs, maintenance, and superintendence.  For the three month and nine month periods ended March 31, 2005, our LOE was $819,093 and $1,815,837, respectively.  For the nine month period ended March 31, 2005, the LOE per BOE was $21.55.  We incurred an unusually high amount of LOE to implement the operational improvements at all fields, as previously discussed.  We will continue to evaluate potential operational improvements for all three fields.  We anticipate these expenditures will lead to improved operational efficiency and reduced operating expenses in future months.

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Our general and administrative expenses consist of support services for our operating activities, along with investor relation costs during the current quarter and nine month period of approximately $136,000 and $572,000, respectively.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements as of March 31, 2005 or as of the date of this report.

Item 3.  Controls and Procedures.

As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our chief executive officer and chief financial officer of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act). Based upon this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.  There was no change in our internal controls or in other factors that could affect these controls during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1.  Legal Proceedings.

Occasionally, we are involved in various lawsuits and certain governmental proceedings arising in the ordinary course of business.  Our management and legal counsel do not believe that the ultimate resolution of such matters, will have a material effect on our financial position or results of operations.  None of our directors, officers or affiliates is involved in a proceeding adverse to our business or has a material interest adverse to our business.

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

On March 18, 2005, we entered into agreements to sell 1,350,000 shares of common stock to two accredited institutional investors at a price of $3.75 per share.  The transactions closed on March 24, 2005.

On March 29, 2005, we completed the acquisition of Square One Energy, Inc. in consideration for $7.5 million, consisting of $4 million in cash and 888,888 shares of our common stock, which was valued at $3.96 per share.

 All of the above unregistered issuances of securities were made pursuant to the exemption from registration requirements provided by Section 4(2) of the Securities Act of 1933, as amended, and/or Rule 506, promulgated thereunder.  Except as expressly set forth above, the individuals and entities to whom we issued securities are unaffiliated with us. For each of the above sales of unregistered securities, no advertising or general solicitation was employed in offering the securities. The offerings and sales were made to a limited number of persons, all of whom were accredited investors, business associates of ours or our executive officers, and transfer was restricted by us in accordance with the requirements of the Securities Act of 1933, as amended. Each of the above security holders who were not our executive officers represented that the are accredited and sophisticated investors, that they are capable of analyzing the merits and risks of their investment, and that they understand the speculative nature of their investment. Furthermore, all of the above-referenced persons had access to our Securities and Exchange Commission filings.

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Item 3.  Defaults Upon Senior Securities.

There has been no material default in the payment of principal, interest, a sinking or purchase fund installment, or any other material default not cured within 30 days, with respect to any indebtedness exceeding five percent of our total assets.  There also is no material arrearage in the payment of dividends or any other material delinquency not cured within 30 days, with respect to any class of preferred stock which is registered or which ranks prior to any class of our registered securities, or with respect to any class of preferred stock of any significant subsidiary.

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

There were no matters submitted to a vote of security holders during the period covered by this report.

Item 5.  Other Information.

None.

Item 6.  Exhibits.

References to “the Company” in the following exhibit list mean Cano Petroleum, Inc., a Delaware corporation.

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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