UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-KSB/A

Amendment No. 1

(Mark One)

x		ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JUNE 30, 2006
o		TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE TRANSITION PERIOD FROM                          TO                          

COMMISSION FILE NUMBER

CANO PETROLEUM, INC.

(Name of small business issuer in its charter)

 

Issuer’s telephone Number: (817) 698-0900

Securities registered under Section 12(b) of the Exchange Act:

 

Securities registered under Section 12(g) of the Exchange Act: NONE

Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.    o

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 x     No o

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.  o

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

State issuer’s revenues for its most recent fiscal year.  $18,407,786

The aggregate market value of the voting and non-voting common equity held by non-affiliates, computed by reference to the average bid and asked price of such common equity as of December 18, 2006 was $130,549,000.  (All directors, executive officers and known beneficial owners of at least 10% of the common stock have been assumed to be affiliates).

As of December 26, 2006, the issuer had 32,308,894 outstanding shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE: NONE

Transitional Small Business Disclosure Format (check one): Yes o     No x

TABLE OF CONTENTS

Explanatory Note
	PART II
Item 6.	Management’s Discussion and Analysis
Item 7.	Financial Statements
Item 8A.	Controls and Procedures
	PART III
Item 13.	Exhibits
SIGNATURES

 

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EXPLANATORY NOTE

                This Amendment No. 1 on Form 10-KSB/A is being filed with regard to the Annual Report on Form 10-KSB for the fiscal year ended June 30, 2006, filed with the Securities and Exchange Commission on September 25, 2006 for the purposes of (i) amending and restating Part II, Item 6. “Management’s Discussion and Analysis:” (a) to reflect that we intend to implement Phase I of full-field waterflood injection operations in the Panhandle Field rather than a pilot waterflood injection operation; (b) to reflect that the average price that we received for crude oil sales is generally at or above posted prices in the field and that the average price we receive for natural gas sales is approximately the market (indexed) price less marketing and other purchaser expenses; (c)  to add to the “Significant Accounting Policies” regarding “Oil and Gas Properties and Equipment” additional disclosure regarding our units-of-production amortization rates and depletion of our development costs, lease and wellhead equipment and leasehold costs; (d) to add to the “Significant Accounting Policies” regarding “Revenue Recognition” that we do not incur transportation costs related to the sales of our oil and natural gas production; and (e) to reflect the appropriate revision to “Management’s Discussion and Analysis” resulting from the modifications to our Consolidated Financial Statements described below; (ii) amending and restating Part II, Item 8A. “Controls and Procedures” to reflect that with regard to the control deficiency relating to accounting for income taxes, we increased the review and communication with our third party tax preparer beginning during the preparation of the income tax accrual for the quarter ended September 30, 2006; and (iii) amending and restating our Consolidated Financial Statements: (a) to add two new line items to the Consolidated Balance Sheet “Prepaid assets” and “Inventory” and to decrease “Other current assets” by the amount of the two new line items; (b) to delete the line item “Stock compensation expense” from the Consolidated Statements of Operations and to add such amounts to the line item “General and administrative, including stock compensation expense of $570,523 and $1,823,040, respectively;” (c) to modify Note 1 regarding “Oil and Gas Properties and Equipment” to add disclosure regarding our units-of-production amortization rates and depletion of our development costs, lease and wellhead equipment and leasehold costs; (d) to modify Note 1 regarding “Revenue Recognition” to reflect that we do not incur transportation costs related to the sales of our oil and natural gas production; (e) to modify Note 14 regarding Costs Incurred in Oil and Gas Producing Activities to delete the line items “Workover expenses” and “Asset retirement costs recognized according to SFAS No. 143,” to increase the amounts in the line item “Development costs” and to decrease the amounts in the line item “Total Costs Incurred;” and (f) to modify Note 14 regarding Standardized Measure of Discounted Future Cash Flows to make “Future development costs” a separate line item and to modify “Future production costs” accordingly.

                This Form 10-KSB/A does not reflect events occurring after the filing of the original Form 10-KSB, and does not modify or update the disclosure therein other than as required to reflect the amendments described above and set forth below.  Accordingly, this Amendment No. 1 on  Form 10-KSB/A should be read in conjunction with our original Form 10-KSB for the fiscal year ended June 30, 2006.  In addition, the filing of this Form 10-KSB/A should not be deemed an admission that the original filing, when made, included any untrue statement of a material fact or omitted to state a material fact necessary to make a statement made therein not misleading.  This Form 10-KSB/A should be read in conjunction with our filings made with the Securities and Exchange Commission subsequent to the filing of the original Form 10-KSB for the fiscal year ended June 30, 2006, including any amendments to those filings.  In addition, pursuant to the rules of the Securities and Exchange Commission, Exhibits 31.1, 31.2, 31.3, 32.1, 32.2 and 32.3 of the original Form 10-KSB have been amended and filed herewith to contain currently dated certifications from our Chief Executive Officer, Chief Financial Officer and Principal Accounting Officer.

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PART II

Item 6.          Management’s Discussion and Analysis.

Forward-Looking Statements

The information in this report on Form 10-KSB 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

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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, interest rates, estimates of reserves, drilling risks, geological risks, transportation restrictions, the timing of acquisitions, product demand, market competition, interruption in production, our ability to obtain additional capital, and the success of waterflooding and enhanced oil recovery techniques.

You should read the following discussion and analysis 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 natural gas company that intends to actively pursue enhanced oil recovery techniques to increase production and reserves at our existing properties acquired in the future.  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 EOR technology, such as surfactant-polymer technology.

During our first two years of operations, our primary focus was to achieve growth through acquiring existing, mature oil and natural gas fields.  We believe the portfolio of oil and natural gas properties that we have acquired thus far provide ample opportunities to apply waterflooding and EOR technology.  The potential of these assets is shown in the “Proved Reserves” table included in this section.  During the next twelve months, our emphasis is to achieve growth by developing our existing oil and natural gas properties through development activities such as waterflooding and EOR technology.  These development activities are more clearly defined later in this section under “Capital Spending Plan for Fiscal Year 2007.”

We believe significant acquisition opportunities will continue to 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.  During the past several years, the major companies have been divesting themselves of their mature oilfields.  Also, the recent economics of the crude oil and natural 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 selectively target potential acquisition candidates in a disciplined manner, which involves being financially prudent and acquiring assets that meet our engineering/operational standards.  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 relatively 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 better manage our operating expenses and adhere to our commitment to keep fixed costs low.

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Liquidity and Capital Resources

For the fiscal year ended June 30, 2006, we generated a loss applicable to common stock of $1.8 million.  We had cash used in operating activities of $6,083,774, which includes payments for derivative assets (i.e. hedge contracts) totaling $6,128,402.  At June 30, 2006, we had working capital of $2,164,527, which includes the derivative assets (i.e. hedge contracts) of $1,176,959 and we had unused borrowing capacity of $1.25 million.

As discussed in Note 13, on September 6, 2006, we sold in a private placement 49,116 shares of Series D Convertible Preferred Stock at a price of $1,000.00 per share and 6,584,247 shares of common stock at a price of $4.83 per share, the three day average closing price of the stock prior to the execution of the definitive agreements, plus a warrant component.  The preferred stock has a 7.875% dividend and features a paid-in-kind (“PIK”) provision that allows, at the investor’s option, the investor to receive additional shares of common stock for the dividend in lieu of a cash dividend payment.  Holders of approximately 55% of the preferred stock chose the PIK dividend option.  The convertible preferred stock is convertible to common stock at a price of $5.75 per share and the common stock is subject to 25% warrant coverage at an exercise price of $4.79 per share.  Gross proceeds from the transactions were $80.9 million, of which $49.1 million was preferred stock and common stock was $31.8 million.

Cash proceeds from the financing have been used to repay $68.75 million in long-term debt outstanding at June 30, 2006 as discussed in Note 4, and will be used to provide working capital and for general corporate purposes, including the funding of Cano’s fiscal 2007 capital budget.

The interest rates of the senior and subordinated debt were 8.49% and 12.74% at June 30, 2006, respectively.  Due to repaying the $15 million outstanding balance on the subordinated debt, this debt facility has been permanently retired.  The Senior Credit Agreement, as discussed in Note 4, with an unused borrowing base of $55 million after the pay down, is our only remaining source of debt.

For our fiscal year ended June 30, 2006, our operating results included seven months of WO Energy and two months of the Pantwist properties.  We believe the $80.9 million financing discussed in Note 13; the available borrowing capacity under the Senior Credit Agreement ($55 million at September 15, 2006); and having a full twelve months of operating results from WO Energy and Pantwist for fiscal year 2007 should sufficiently fund our planned capital expenditures and working capital needs through June 30, 2007.   Our capital expenditures are further discussed later in the section titled “Capital Spending Plan for Fiscal Year 2007.” However, no assurance may be given that we will be successful in improving our operating results or the eventual success of our field developmental activities during the next twelve months.

Financing and Investing Activities During Fiscal Year 2006

During the twelve months ended June 30, 2006, our financings consisted of the following:

·                  We received net proceeds of $18.3 million from the issuance of 4,703,864 shares of common stock at a per share price equal to $4.14 during September 2005 (Note 6).

·                  On November 29, 2005, we issued 1,791,320 common shares as part of the WO Energy acquisition, which was valued at $4.60 per share (Note 3).

·                  On November 29, 2005, we entered into a $100 million senior credit agreement with the lenders led by Union Bank of California, N.A., as administrative agent and as issuing lender. The borrowing base is $55 million based on our proved reserves. At June 30, 2006, we had outstanding borrowings of $53.75 million, which have now been repaid (Notes 4 and 13).

·                  On November 29, 2005, we entered into a $15 million subordinated credit agreement with the lenders led by Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio, as administrative agent. At June 30, 2006, we had outstanding borrowings of $15 million, which have now been repaid (Notes 4 and 13).

The proceeds from these issuances of common stock and long-term debt were used to fund the following acquisitions and development activities during the twelve months ended June 30, 2006:

·                  Acquisition of the WO Energy for $57.5 million (Note 3).

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·                  Acquisition of Pantwist properties for $23.4 million (Note 3).

·                  Purchase of an additional 10.5% revenue interest in the Davenport field for $0.7 million (Note 7).

·                  Capital expenditures of $5.7 million, consisting primarily of surfactant-polymer developmental activities, returning non-producing wells to production and implementing environmental safeguards to our existing fields.

As of June 30, 2006, our common stock was the only class of stock outstanding.  As discussed in Note 13, on September 6, 2006, we completed equity issuances of the Series D Convertible Preferred Stock and common stock.

Proved Reserves

Based on reserve reports prepared by Forrest A. Garb & Associates, Inc., independent petroleum engineers dated July 1, 2006, our total reserves are summarized as follows:

				Rich								Panhandle
		Nowata		Valley		Davenport		Desdemona		Corsicana		(WO Energy)		Pantwist		Total
Proved
Oil - Mbbls		1,266		226		1,561		625		848		24,550		4,792		33,868
Gas - Mmcf		232		2,260		157		—		—		52,845		13,608		69,102
Proved Barrels of Equivalent Oil (“MBOE”)		1,305		602		1,587		625		848		33,358		7,060		45,385
Proved Producing		1,305		602		423		234		—		4,673		2,113		9,350

 

Our proved reserves equate to 45,385 MBOE of proved reserves, consisting of (21%) or 9,350 MBOE of proved producing reserves, 1,555 MBOE (3%) of proved non-producing reserves and 34,480 MBOE (76%) of proved undeveloped reserves.

Regarding our proved undeveloped reserves, approximately eighty-three percent (83%), or 28,685 MBOE, are attributable to a Panhandle Field waterflood implementation. Approximately three percent (3%), or 848 MBOE, are attributable to a surfactant-polymer application in the Corsicana Field and fourteen percent (14%), or 4,947 MBOE, are attributable to waterflood implementation for the Pantwist properties. The waterflood implementations for the Panhandle Field and the Pantwist properties, and the waterflood and surfactant-polymer application to the Corsicana Field involve significant capital investment and an extended period of time from the first investment until actual production occurs. Generally, the surfactant-polymer is regarded as more risky as compared to waterflooding; however, the Corsicana Field has been the subject of a successful polymer pilot and we believe conditions for surfactant polymer-flooding are favorable for this field. Our ability to recover and successfully convert proved undeveloped reserves to proved producing reserves is greatly contingent upon our ability in the future to obtain additional financing and/or raise additional capital, and further, greatly contingent upon inherent uncertainties associated with the success of producing crude oil and natural gas from our developmental activities, and volatile crude oil and natural gas prices.

Reserves were estimated using crude oil and natural gas prices and production and development costs in effect on July 1, 2006.  On July 1, 2006, the crude oil and natural gas prices were $73.94 per barrel and $5.83 per MMbtu, respectively.  The values reported may not necessarily reflect the fair market value of the reserves.

Capital Spending Plan for Fiscal Year 2007

Our capital spending plan for the twelve months ended June 30, 2007, excluding potential acquisitions, is projected to be $41 million to implement developmental projects at our existing fields to increase reserves and production as follows:

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Panhandle Field.  We intend to implement Phase I of full-field waterflood injection operations.  This will involve drilling six new wells, converting 25 existing wells to water injection, securing water rights, and designing new facilities.  We expect to see increased production during the quarter ending June 30, 2007.

Desdemona Field.  We intend to implement a waterflood injection operation to the entire field.  This will involve drilling six new wells, converting existing wells to water injection, securing water rights, and designing new facilities.  We expect to see increased production during the quarter ending June 30, 2007. We also intend to drill ten natural gas wells into the Marble Falls formation, which is above the Barnett Shale.  We are evaluating our options regarding our Barnett Shale mineral rights.

Corsicana Field.  This field has had a proven surfactant-polymer chemical injection pilot.  We intend to re-implement a prior waterflood injection operation to the entire field.  This will involve drilling sixteen new wells, converting existing wells to water injection, securing water rights, and designing new facilities.  We expect to see increased production during the quarter ending March 31, 2007. We intend to implement a surfactant-polymer chemical injection during the quarter ending June 30, 2007.

Nowata Field.  This field is currently being waterflooded.  We intend to implement a surfactant-polymer chemical injection pilot project during the quarter ended December 31, 2006.  We expect to see a production response during the quarter ending December 31, 2007.

Davenport Field.  This field is currently being waterflooded.  We intend to workover and bring existing non-producing wells to production.  We are also evaluating this field for surfactant-polymer injection.  This evaluation, coupled with the knowledge gained from the Corsicana and Nowata fields, is expected to enhance its value as a surfactant-polymer candidate.

Based on our current cash resources and other current assets, management believes we have sufficient liquidity to fund operations for the next twelve months.

Results of Operations

Overall

For the twelve months ended June 30, 2006 (“2006 Fiscal Year”), we had a loss applicable to common stock of $1.8 million, which is $1.6 million lower as compared to the $3.4 million loss applicable to common stock incurred for the twelve months ended June 30, 2005 (“2005 Fiscal Year”).

The following table summarizes the differences between the two fiscal years.

 

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Results of oil and natural gas producing operations consist of operating revenues less lease operating expenses, production taxes, accretion of asset retirement obligations, and depletion and depreciation. The $6.4 million increase is attributed to:

·                  Including seven months of operating results from the acquisition of the Panhandle Field (i.e. WO Energy) which contributed $3.5 million to net operating income;

·                  Including two months of operating results from the Pantwist properties which contributed $0.9 million to net operating income;

·                  Including two months of operating results from the Nowata Field which contributed $0.4 million to net operating income; and

·                  Improved operating results from our Davenport, Rich Valley, Desdemona, and Nowata Fields, primarily due to higher crude oil and natural gas prices received and increased sales.

The other factors mentioned in the above table will be addressed in the following discussion.

Operating Revenues

The table below summarizes our operating revenues for the two fiscal years.

 

The 2006 Fiscal Year operating revenues of $18.4 million represent an improvement of $12.9 million as compared to the 2005 Fiscal Year of $5.5 million. The $12.9 million improvement is primarily attributable to:

·                  Including seven months of operating revenue from the Panhandle Field ($7.9 million of revenue and 139 MBOE of sales);

·                  Including two months of operating revenue from the Pantwist properties ($1.5 million of revenue and 24 MBOE of sales);

·                  Including an additional two months of operating revenue from the Nowata Field ($0.8 million of revenue and 12 MBOE of sales);

·                  The higher prices received for crude oil and natural gas sales; and

·                  Increased sales of 15 MBOE from the other fields.

The average price we received for crude oil sales is generally at or above posted prices in the field. The average price we receive for natural gas sales is approximately the market (indexed) price less marketing and other purchaser marketing expenses.  Excluding the effect of the natural gas hedge, the natural gas price we received was $8.09/Mcf.

During March 2006, there were grass fires in the Texas Panhandle area. These fires temporarily shut-in production at the Panhandle Field until flow lines were restored. We estimate the temporary shut-in resulted in approximately $0.3 million reduction in revenues for March and April 2006. By mid-April 2006, the Panhandle Field was producing at 95% of normal operations.

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We expect future increases to sales through capital expenditures as previously discussed in “Plan of Operation - Capital Spending Plan for Fiscal Year 2007.”

Operating Expenses

For the 2006 Fiscal Year, our total operating expenses were $18.0 million, or $9.5 million higher than the 2005 Fiscal Year of $8.5 million. The $9.5 million increase is primarily attributed to:

·                  Including seven months of the Panhandle Field operating expenses totaling $4.4 million;

·                  Including two months of the Pantwist properties operating expenses totaling $0.6 million;

·                  Including two additional months of the Nowata Field operating expenses totaling $0.4 million;

·                  Higher general & administrative expenses of $3.0 million, reflecting lower deferred compensation expense of $1.2 million; and

·                  Higher other operating expenses of $0.4 million.

Our lease operating expenses (“LOE”) consists of the costs of producing crude oil and natural gas such as labor, supplies, repairs, maintenance, and utilities.  For the 2006 Fiscal Year, the LOE per BOE was $22.32 per BOE, which is slightly lower than the $22.88 we incurred during 2005 Fiscal Year. We generally incur a high amount of LOE because our fields are more mature and typically produce less oil and more water, and they are generally at the end of the primary or secondary production cycle. 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. Based on management’s past experience, it generally requires up to twelve months to fully analyze the acquired field and spend the necessary funds to improve the field operations to meet our operational standards.  We expect these expenditures should lead to increased operational efficiency and reduced operating expenses in future periods.

Our general and administrative (G&A) expenses consist of support services for our operating activities and investor relations costs. For the 2006 Fiscal Year, our G&A expenses totaled $7.8 million, which is $3.0 million higher than the 2005 Fiscal Year of $4.8 million. The primary contributors to the $3.0 million increase were:

·                  Increased labor and staffing costs of $1.8 million;

·                  Higher legal fees of $1.1 million to comply with regulatory requirements and for litigation;

·                  Expenses associated with the Sabine joint venture of $0.4 million, as discussed in Note 7;

·                  Expenses of $0.3 million to maintain the WO Energy offices; and

·                  Other items totaling $0.6 million due to higher travel costs, board of director compensation, higher accounting fees and increased insurance costs.

 

Offsetting these increases was lower deferred compensation expense of $1.2 million.

On January 6, 2006, our Board of Directors approved the following non-executive director compensation schedule. Each director shall receive an annual cash retainer of $25,000. Each director shall be paid $1,000 cash for each Board meeting and Board committee meeting attended. The Audit Committee Chairman shall receive an additional annual cash retainer of $5,000. The Compensation Committee Chairman, the Corporate Governance Committee Chairman, the Nominating Committee Chairman and the chairman of any other committee or special committee established by the Board shall be paid an additional annual cash retainer of $3,000.

Our payroll and payroll-related costs comprise $3.0 million, or 42% of our total G&A expenses.  We expect these costs to continue to increase because the recent growth in the petroleum industry has increased competition for labor resources.

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Loss on Hedging Contracts

As discussed in Note 5, we paid $6.1 million to enter into financial contracts to set price floors for crude oil and natural gas through April 2009. In accordance with SFAS 133, we recorded a Loss on Hedging Contracts of $3.2 million to reflect the fair value of the derivative instruments as of June 30, 2006. By their nature, these derivative instruments can be highly volatile to our earnings. A five percent change in these prices for our derivative instruments can impact earnings by approximately $144,000. We did not have hedging contracts during the 2005 Fiscal Year.

Also, during the 2006 Fiscal Year, as discussed in Note 5, there were settlements under our derivative agreements due to Cano amounting to $540,871. The settlements were cumulative monthly payments due to Cano since the NYMEX natural gas price was lower than the $8.50 and $7.60 “floor natural gas price.” Such payments are included in crude oil and natural gas sales on our consolidated statement of operations for the year ended June 30, 2006.

As discussed in Note 4, the Senior Credit Agreement requires that we implement financial hedge contracts to cover no less than 50% and no more than 80% of the production volumes attributable to our proved, developed and producing proven reserves.  We are required to maintain three year hedges, and to update our hedges semi-annually.  We intend to enter into financial contracts to set price floors for our crude oil and natural gas production.

Interest Expense

The interest expense of $2.6 million that we incurred in the 2006 Fiscal Year resulted directly from senior and subordinated credit agreements we entered into on November 29, 2005, as discussed in Note 4. We did not have credit agreements during the 2005 Fiscal Year.

As discussed under Liquidity and Capital Resources and Note 13, on September 6, 2006, we completed a private placement of preferred stock, common stock and warrants totaling gross proceeds of $80.9 million.  The preferred dividend rate is 7.875%.  These proceeds have been used to repay long-term debt of $68.75 million as of June 30, 2006, and the remainder will be used to provide working capital and for general corporate purposes, including the funding of our fiscal 2007 capital budget.  Our outstanding subordinated debt totaling $15 million, with an interest rate of 12.74%, has been permanently retired.  We intend to borrow against the Senior Credit Agreement, with an available borrowing base of $55 million, as needed to fund capital spending and working capital needs.

Deferred Income Tax Benefit

As the result of the recognition of the deferred tax liabilities assumed in the acquisitions of WO Energy and Square One, as discussed in Notes 3 and 11, to the financial statements, we have recorded a net deferred tax liability. This allows us to recognize deferred tax benefits from generation of net operating losses because a valuation allowance against such items is not required. We review our deferred tax assets at least quarterly and record a valuation allowance against those assets when we conclude that it is more likely than not that those assets will expire without being utilized. For the 2006 Fiscal Year, we recorded a deferred income tax benefit of $3,498,000.  This benefit amounts to an effective tax rate of approximately 65%, due to recording the effect of a change in enacted rates in the State of Texas in May 2006, amounting to $1,840,000. See Note 11 for more information.

Preferred Stock Discount

The reduced preferred stock discount amounting to $0.4 million occurred during the 2005 Fiscal Year and was attributable to certain issuances of preferred stock during that period. Since we did not issue preferred stock during the 2006 Fiscal Year, there is no preferred stock discount for the 2006 Fiscal Year.

Contractual Obligations

The following table sets forth our contractual obligations in thousands at June 30, 2006 for the periods shown:

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		Total			Less than One Year			One To Three Years			Three to Five Years			More Than Five Years
Long-term debt (1)		$	68,750		$	0		$	68,750		$	0		$	0
Operating lease obligations		$	1,648		$	157		$	756		$	735		$	0
Total contractual obligations		$	70,398		$	157		$	69,506		$	735		$

 

(1) As discussed in Note 13, the long-term debt was fully repaid with equity financing in September 2006.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements.

Significant Accounting Policies

Consolidation and Use of Estimates

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Cano and its wholly-owned subsidiaries.  Intercompany accounts and transactions are eliminated.  In preparing the accompanying financial statements, management has made certain estimates and assumptions that affect reported amounts in the financial statements and disclosures of contingencies. Actual results may differ from those estimates.  Significant assumptions are required in the valuation of proved oil and natural gas reserves, which may affect the amount at which oil and gas properties are recorded.  It is at least reasonably possible these estimates could be revised in the near term, and these revisions could be material.

Oil and Gas Properties and Equipment

We follow the successful efforts method of accounting, capitalizing costs of successful exploratory wells and expensing costs of unsuccessful exploratory wells.  All developmental costs are capitalized.  We are predominately engaged in the acquisition and development of proved reserves as opposed to exploration activities.  The property costs reflected in the accompanying balance sheet were acquired in the merger and subsequent acquisitions, as discussed in Notes 2 and 3.  Cano had capitalized costs for its oil and natural gas properties of $133,176,618 at June 30, 2006.

Depreciation and depletion of producing properties is computed on the units-of-production method based on estimated proved oil and natural gas reserves.  Repairs and maintenance are expensed, while renewals and betterments are generally capitalized.

Our units-of-production amortization rates are revised on a quaterly basis. Our development costs and lease and wellhead equipment are depleted based on proved developed reserves. Our leasehold costs are depleted based on total proved reserves.

At least quarterly, or more frequently if conditions indicate that long-term assets may be impaired, the carrying value of property is compared to management’s future estimated pre-tax cash flow from the properties.  In accordance with Statement of Financial Accounting Standards No. 144, Accounting for Impairment or Disposal Of Long-Lived Assets, if impairment is necessary, the asset carrying value is written down to fair value. Cash flow pricing estimates are based on existing proved reserve and production information and pricing assumptions that management believes are reasonable. Impairment of individually significant unproved properties is assessed on a property-by-property basis, and impairment of other unproved properties is assessed and amortized on an aggregate basis.  We had no significant unproved properties at June 30, 2006.  No impairment was necessary at June 30, 2006.

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Asset Retirement Obligation

Our financial statements reflect the provisions of Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations.  SFAS No. 143 provides that, if the fair value for an asset retirement obligation can be reasonably estimated, the liability should be recognized upon acquiring or drilling a well.  Under the method prescribed by SFAS No. 143, the retirement obligation is recorded as a liability at its estimated present value at the asset’s inception, with an offsetting increase to producing properties on the balance sheet.  Periodic accretion of the discount of the estimated liability is recorded as an expense in the statement of operations.

Goodwill

The amount paid for the transaction described in Notes 2 and 11 in excess of the fair value of the net assets acquired has been recorded as “Goodwill” in the Consolidated Balance Sheet.  Goodwill is not amortized, but is assessed for impairment annually or whenever conditions would indicate impairment may exist.  There were no impairments recorded in either of the fiscal years ended June 30, 2005 and 2006.

Accounts Receivable

Accounts receivable principally consists of oil and natural gas sales proceeds receivable, typically due within 35 days of oil and natural gas production, respectively. We require no collateral for such receivables, nor do we charge interest on past due balances. We periodically review receivables for collectibility and reduce the carrying amount of the receivables by an allowance. No such allowance was indicated at June 30, 2005 or 2006. As of June 30, 2006, our accounts receivable were primarily held by several independent purchasers of our crude oil and natural gas production. At June 30, 2006, we had balances due from four customers which were greater than 10% of our accounts receivable related to oil and natural gas production.  These four customers had 29%, 24%, 14% and 12% of accounts receivable related to oil and natural gas production, respectively.

Revenue Recognition

We recognize revenue when crude oil and natural gas quantities are delivered to or collected by the respective purchaser.  Title to the produced quantities transfers to the purchaser at the time the purchaser collects or receives the quantities.  Prices for such production are defined in sales contracts and are readily determinable based on certain publicly available indices.  The purchasers of such production have historically made payment for crude oil and natural gas purchases within thirty-five days of the end of each production month.  We periodically review the difference between the dates of production and the dates we collect payment for such production to ensure that receivables from those purchasers are collectible. The point of sale for our oil and natural gas production is at our applicable field gathering system; therefore, we do not incur transportation costs related to our sales of oil and natural gas production.

As of June 30, 2005 and 2006, we sold our crude oil and natural gas production to several independent purchasers. During the twelve months ended June 30, 2005, we had sales to primarily three customers which represented 58%, 21% and 19% of total operating revenue, respectively.  During the twelve months ended June 30, 2006, we had sales of 10% or more of our total revenues to five customers representing 29%, 25%, 12%, 12% and 10% of total operating revenue, respectively.

Income Taxes

We began our oil and natural gas operations on May 28, 2004.  Since, for the twelve month period ended June 30, 2005, we had incurred a net loss and had not yet generated book or tax income, our consolidated statement of operations through June 30, 2005 did not reflect a provision for income taxes.

We began to record income taxes in the quarter ended December 31, 2005 as a result of the acquisition of WO Energy.  This is more fully discussed in Note 11.

Deferred tax assets or liabilities are recognized for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of the Company’s assets and liabilities. 

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These balances are measured using tax rates in effect for the year in which the differences are expected to reverse.  A valuation allowance for deferred tax assets is recorded when it is more likely than not that the benefit from the deferred tax asset will not be realized.

Stock Compensation Expense

We account for share-based payments for services provided by employee to employer in accordance with Statement of Financial Accounting Standard No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation.  SFAS 123 requires companies to expense the fair value of employee stock options and other equity-based compensation at the grant date.

Derivative Hedging Contracts

We are required to enter into financial contracts to hedge a portion of our production at specified prices for oil and natural gas. The objective of the hedging contracts is to reduce our exposure to commodity price risk associated with expected oil and natural gas production.  We have purchased hedging contracts that set “price floors” for our crude oil and natural gas production.

We have no derivative hedging contracts that set a price ceiling. We do not designate our derivatives as cash flow or fair value hedges. We do not hold or issue derivative financial instruments for speculative or trading purposes. We are exposed to credit losses in the event of nonperformance by the counterparties to our financial hedging contracts. We anticipate, however, that our counterparty, Union Bank of California, will be able to fully satisfy their obligations under the contracts. We do not obtain collateral or other security to support our financial hedging contracts subject to credit risk but we monitor the credit standing of the counterparties.

We have elected not to designate the derivative financial instruments to which we are a party as hedges, and accordingly, we record such contracts at fair value and recognize changes in such fair value in current earnings as they occur.

New Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment.” SFAS No. 123(R) revises SFAS No. 123, “Accounting for Stock-Based Compensation,” and focuses on accounting for share-based payments for services provided by employee to employer. The statement requires companies to expense the fair value of employee stock options and other equity-based compensation at the grant date. The statement does not require a certain type of valuation model, and either a binomial or Black-Scholes model may be used.  We intend to adopt this SFAS 123(R) beginning July 1, 2006.  Since we currently expense stock options granted to employees in accordance with SFAS 123, management does not believe that the adoption of SFAS No. 123(R) will materially impact our operating results, financial position, or our future cash flows.

On July 13, 2006, the FASB released FIN 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109.”  FIN 48 requires companies to evaluate and disclose material uncertain tax positions it has taken with various taxing jurisdictions.  We are currently reviewing FIN 48 and are unable to determine the effect, if any, that FIN 48 will have to our operating results, financial position, or future cash flows.

Item 7.          Financial Statements.

The Report of Independent Registered Public Accounting Firm and Consolidated Financial Statements are set forth beginning on page F-1 of this annual report on Form 10-KSB and are incorporated herein.  The financial statement schedules have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or the Notes to the Consolidated Financial Statements.

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Item 8A.       Controls and Procedures.

Evaluation of Disclosure 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, chief financial officer and principal accounting 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, chief financial officer and principal accounting officer concluded that our disclosure controls and procedures were not effective to ensure that all information required to be disclosed by us in the reports that we file or submit under the Exchange Act is: (1) accumulated and communicated to our management, including our chief executive officer, chief financial officer and principal accounting officer, as appropriate to allow timely decisions regarding required disclosure; and (2) recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. This specifically pertained to matters related to accounting for income taxes discussed below.

We did not maintain effective controls over the preparation and review of deferred tax liabilities and the related deferred income tax benefit. Specifically, this pertained to apportioning taxes between states to correctly account for the effect of changes to the state of Texas tax laws in May 2006, as discussed in Note 11. This control deficiency could result in a misstatement of deferred tax liabilities and the related deferred income tax benefit. Internal contols have been strengthened through increased review and communication between Cano and the third-party tax preparer.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting identified in connection with the evaluation of internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

However, given the subsequent identification of the above control deficiency relating to accounting for income taxes, we have increased the review and communication between us and our third party tax preparer, which began during the preparation of the income tax accrual for the quarter ended September 30, 2006.

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PART III

Item 13.         Exhibits. 

Exhibit Number		Description
2.1		Agreement and Plan of Merger made as of the 26th day of May 2004, by and among Huron Ventures, Inc., Davenport Acquisition Corp., Davenport Field Unit Inc., the shareholders of Davenport Field Unit Inc., Cano Energy Corporation and Big Sky Management Ltd., incorporated by reference from Exhibit 99.1 to Current Report on Form 8-K, filed on June 8, 2004.
2.2		Management Stock Pool Agreement dated May 28, 2004, incorporated by reference from Exhibit 2.2 to Current Report on Form 8-K/A, filed on August 11, 2004.
2.3		Investment Escrow Agreement dated May 28, 2004, incorporated by reference from Exhibit 2.3 to Current Report on Form 8-K/A, filed on August 11, 2004.
2.4		Stock Purchase Agreement dated June 30, 2004, by and between Cano Petroleum, Inc., as Buyer, and Jerry D. Downey and Karen S. Downey, as Sellers, incorporated by reference from Exhibit 99.1 to Current Report on Form 8-K, filed on July 15, 2004.
2.5		Purchase and Sale Agreement, dated August 16, 2004, by and between Cano Energy Corporation and Cano Petroleum, Inc., incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K, filed on August 25, 2004.
2.6		Purchase and Sale Agreement, dated September 2, 2004, by and between Nowata Oil Properties LLC and Cano Petroleum, Inc., incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K, filed on September 20, 2004.
2.7		Purchase and Sale Agreement dated February 6, 2005 by and between Square One Energy, Inc. and Cano Petroleum, Inc., incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on March 7, 2005.
2.8		Stock Purchase Agreement by and among Cano Petroleum, Inc., W. O. Energy of Nevada, Inc., Miles O’Loughlin and Scott White dated November 29, 2005 (the schedule and exhibits have been omitted from this filing. An exhibit to the schedules and exhibits is contained in the Stock Purchase Agreement and the schedule and exhibits are available to the Securities and Exchange Commission upon request), incorporated by reference from Exhibit 2.1 to Current Report on Form 8-K filed on December 5, 2005.
2.9		Asset Purchase and Sale Agreement among Myriad Resources Corporation, Westland Energy Company and PAMTEX, a Texas general partnership composed of PAMTEX GP1 Ltd. and PAMTEX GP2 Ltd., as Sellers, and Cano Petroleum, Inc. as Buyer dated as of April 25, 2006 (The schedules and exhibits have been omitted from this filling. An exhibit to the

 

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		schedules and exhibits is contained in the Asset Purchase and Sale Agreement and the schedules and exhibits are available to the Securities and Exchange Commission upon request), incorporated by reference from Exhibit 2.1 to Quarterly Report on Form 10-QSB filed on May 15, 2006.
2.10		Amendment No. One to Stock Purchase Agreement by and among Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., Estate of Miles O’Loughlin and Scott White dated May 13, 2006 incorporated by reference from Exhibit 2.1 to Current Report on Form 8-K filed on May 15, 2006.
3.1		Certificate of Incorporation, incorporated by reference from Exhibit 3.1 to the Company’s registration statement on Form 10-SB (File No. 000-50386), filed on September 4, 2003.
3.2		Certificate of Ownership, amending the Company’s Certificate of Incorporation, incorporated by reference from Exhibit 3.2 to the Company’s Annual Report on Form 10-KSB filed on September 23, 2004.
3.3		Bylaws, incorporated by reference from Exhibit 3.2 to the Company’s registration statement on Form 10-SB (File No. 000-50386), filed on September 4, 2003.
3.4		Designation for Series A Convertible Preferred Stock, included in the Company’s Certificate of Incorporation, incorporated by reference from Exhibit 3.1 to the Company’s registration statement on Form 10-SB (File No. 000-50386), filed on September 4, 2003.
3.5		Certificate of Designation for Series B Convertible Preferred Stock, incorporated by reference from Exhibit 99.2 to Current Report Form 8-K, filed on June 8, 2004.
3.6		Certificate of Designation for Series C Convertible Preferred Stock, incorporated by reference from Exhibit 99.2 to Current Report Form 8-K, filed with the Securities and Exchange Commission on July 15, 2004.
3.7		Certificate of Designation for Series D Convertible Preferred Stock incorporated by reference from Exhibit 3.1 to Current Report on Form 8-K, filed on September 7, 2006.
4.1		Registration Rights Agreement by and between Cano Petroleum, Inc. and Miles O’Loughlin dated November 29, 2005, incorporated by reference from Exhibit 4.1 to Current Report on Form 8-K filed on December 5, 2005.
4.2		Registration Rights Agreement by and between Cano Petroleum, Inc. and Scott White dated November 29, 2005, incorporated by reference from Exhibit 4.2 to Current Report on Form 8-K filed on December 5, 2005.
4.3		Amendment No. One to the Registration Rights Agreement by and between Cano Petroleum, Inc. and Estate of Miles O’Loughlin dated May 13, 2006 and effective as of November 29, 2005 incorporated by reference from Exhibit 4.1 to Current Report on Form 8-K filed on May 15, 2006.
4.4		Amendment No. One to the Registration Rights Agreement by and between Cano Petroleum, Inc. and Scott White dated May 13, 2006 and effective as of November 29, 2005 incorporated by reference from Exhibit 4.2 to Current Report on Form 8-K filed on May 15, 2006.
4.5		Registration Rights Agreement dated August 25, 2006 by and among Cano Petroleum, Inc. and the Buyers listed therein, incorporated by reference from Exhibit 4.1 to Amendment to Current Report on Form 8-K/A filed on August 31, 2006.
10.1		Subscription Agreement of Randall Boyd, dated October 8, 2004, incorporated by reference from Exhibit 4.1 to Current Report on Form 8-K, filed on February 14, 2005.
10.2+		Stock Option Agreement dated December 16, 2004 between Cano Petroleum, Inc. and Gerald W. Haddock, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on December 16, 2004.
10.3		Form of Subscription Agreement entered into March 18, 2005, incorporated by reference from Exhibit 4.1 to Current Report on Form 8-K filed on March 28, 2005.
10.4		Letter agreement dated March 29, 2005 among the Haddock Enterprises, LLC, the Company and Kenneth Carlile, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on April 1, 2005.
10.5+		2005 Directors’ Stock Option Plan, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on June 28, 2005.

 

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10.6		SPP Transaction Summary dated August 4, 2005, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K, filed on August 9, 2005.
10.7		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and Howard Hughes Medical Institute, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on September 22, 2005.
10.8		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and The Robert Wood Johnson Foundation, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K filed on September 22, 2005.
10.9		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and Laborers’ District Council and Contractors’ of Ohio Pension Fund, incorporated by reference from Exhibit 10.3 to Current Report on Form 8-K filed on September 22, 2005.
10.10		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and Ohio Carpenters’ Pension Fund, incorporated by reference from Exhibit 10.4 to Current Report on Form 8-K filed on September 22, 2005.
10.11		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and New York Nurses Association Pension Plan, incorporated by reference from Exhibit 10.5 to Current Report on Form 8-K filed on September 22, 2005.
10.12		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and Public Sector Pension Investment Board, incorporated by reference from Exhibit 10.6 to Current Report Form 8-K filed on September 22, 2005.
10.13		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and Spindrift Investors (Bermuda) L.P., incorporated by reference from Exhibit 10.7 to Current Report on Form 8-K filed on September 22, 2005.
10.14		Subscription Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and Spindrift Partners, L.P., incorporated by reference from Exhibit 10.8 to Current Report on Form 8-K filed on September 22, 2005.
10.15+		Employment Agreement dated as of July 11, 2005 by and between Cano Petroleum, Inc. and James K. Teringo, Jr., incorporated by reference from Exhibit 10.9 to Current Report on Form 8-K filed on September 22, 2005.
10.16+		Stock Option Agreement dated September 16, 2005 by and between Cano Petroleum, Inc. and James K. Teringo, Jr., incorporated by reference from Exhibit 10.10 to Current Report on Form 8-K filed on September 22, 2005.
10.17		Subscription Agreement dated September 14, 2005 by and between Cano Petroleum, Inc. and Touradji Global Resources Master Fund, Ltd., incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K on September 20, 2005.
10.18		Subscription Agreement dated September 14, 2005 by and between Cano Petroleum, Inc. and Renaissance US Growth Investment Trust PLC, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K filed on September 20, 2005.
10.19		Subscription Agreement dated September 14, 2005 by and between Cano Petroleum, Inc. and BFS US Special Opportunities Trust PLC, incorporated by reference from Exhibit 10.3 to Current Report on Form 8-K filed on September 20, 2005.
10.20		Subscription Agreement dated September 14, 2005 by and between Cano Petroleum, Inc. and Crestview Capital Master, LLC, incorporated by reference from Exhibit 10.4 to Current Report on Form 8-K filed on September 20, 2005.
10.21		Sabine Production Partners Transition Summary, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on August 9, 2005.
10.22		Omnibus Agreement among Cano Petroleum, Inc., Haddock Enterprises, LLC, Carlile Management, LLC and Sabine Partners, LP dated November 4, 2005, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on November 9, 2005.
10.23		Amended and Restated Regulations of Sabine Production Operating, LLC among Cano Petroleum, Inc., Haddock Enterprises, LLC and Carlile Management, LLC dated November 4, 2005, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K filed on November 9, 2005.
10.24		Compensation Reimbursement Agreement between Cano Petroleum, Inc. and Sabine Production Operating, LLC dated November 4, 2005, incorporated by reference from Exhibit 10.3 to Current Report on Form 8-K filed on November 9, 2005.

 

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10.25		Credit Agreement among Cano Petroleum, Inc., as Borrower, The Lenders Party Hereto From Time to Time, as Lenders, and Union Bank of California, N.A., as Administrative Agent and as issuing Lender, dated November 29, 2005, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on December 5, 2005.
10.26		Subordinated Credit Agreement among Cano Petroleum, Inc., as Borrower, The Lenders Party Hereto From Time to Time, as Lenders, and Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio, as Administrative Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K filed on December 5, 2005.
10.27		Guaranty Agreement by and among Ladder Companies, Inc., Square One Energy, Inc., W.O. Energy of Nevada, Inc., W.O. Energy, Inc., W.O. Operating Company, Ltd. and W.O. Production Company, Ltd. in favor of Union Bank of California, N.A., as Administrative Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.3 to the Current Report on Form 8-K filed on December 5, 2005.
10.28		Guaranty Agreement by and among Ladder Companies, Inc., Square One Energy, Inc., W.O. Energy of Nevada, Inc., W.O. Energy, Inc., W.O. Operating Company, Ltd. and W. O. Production Company, Ltd. in favor of Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio, as Administrative Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.4 to the Current Report on Form 8-K filed on December 5, 2005.
10.29		Escrow Agreement by and among Cano Petroleum, Inc., Miles O’Loughlin, Scott White and The Bank of New York Trust Company, N.A., as Escrow Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.5 to the Current Report on Form 8-K filed on December 5, 2005.
10.30		Pledge Agreement by and among Cano Petroleum, Inc., W. O. Energy of Nevada, Inc. and W O Energy, Inc. in favor of Union Bank of California, N.A., as Administrative Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.6 to the Current Report on Form 8-K dated on December 5, 2005.
10.31		Security Agreement by and among Cano Petroleum, Inc., Ladder Companies Inc., Square One Energy, Inc., W. O. Energy of Nevada, Inc., W O Energy, Inc., W. O. Operating Company, Ltd. and W. O. Petroleum, Ltd., in favor of Union Bank of California N.A. as Administrative Agent, dated November 29, 2005, incorporated by reference from Exhibit 10.7 to the Current Report on Form 8-K filed on December 5, 2005.
10.32+		Cano Petroleum, Inc. 2005 Long-Term Incentive Plan dated December 7, 2005, incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed on December 9, 2005.
10.33+		Form of Stock Option Agreement, incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed on December 19, 2005.
10.34		Summary of Terms of Purchase of Overriding Royalty Interests by Cano Petroleum, Inc. from Theprivate Energy Company, Inc. dated December 27, 2005, incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed on January 3, 2006.
10.35+		Summary Sheet: Director Compensation, incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed on January 12, 2006.
10.36+		Employment Agreement between Cano Petroleum, Inc. and S. Jeffrey Johnson dated effective January 1, 2006, incorporated by reference from Exhibit 10.1 to the Current Report on Form 8-K filed on January 19, 2006.
10.37+		Amendment to Employment Agreement of Thomas Cochrane effective January 1, 2006, incorporated by reference from Exhibit 10.3 to the Current Report on Form 8-K filed on January 19, 2006.
10.38+		Amendment to Employment Agreement of James K. Teringo, Jr. effective January 1, 2006, incorporated by reference from Exhibit 10.4 to the Current Report on Form 8-K filed on January 19, 2006.
10.39		Gas Purchase Contract between W. O. Operating Company, Ltd. and Duke Field Services L.P. dated November 1, 2003, incorporated by reference from Exhibit 10.17 to the Quarterly Report on Form 10-QSB filed on February 14, 2006.
10.40		Gas Purchase Contract by and between W. O. Operating Company Limited, as Seller, and

 

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		One OK Texas Field Services LP, as Buyer, dated January 1, 2005, incorporated by reference from Exhibit 10.18 to the Quarterly Report on Form 10-QSB filed on February 14, 2006.
10.41		Amendment No. 1 dated February 24, 2006 to the $100,000,000 Credit Agreement among Cano Petroleum, Inc., as Borrower, The Lenders Party Hereto From Time to Time as Lenders and Union Bank of California, N.A., as Administrative Agent and as Issuing Lender dated November 29, 2005 incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on March 1, 2006.
10.42		Amendment No. 2, Assignment and Agreement dated as of April 28, 2006 among Cano Petroleum, Inc., Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc., W.O. Operating Company, Ltd., W.O. Production Company, Ltd., Pantwist, LLC, the Lenders and Union Bank of California, N.A., as Administrative Agent and as Issuing Lender, incorporated by reference from Exhibit 10.7 to Quarterly Report on Form 10-QSB filed on May 15, 2006.
10.43		First Amendment to Subordinated Credit Agreement dated as of April 28, 2006 by and among Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio, as Administrative Agent and Lender, UnionBanCal Equities, Inc., Cano Petroleum, Inc., Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc., W.O. Operating Company, Ltd., W.O. Production Company, Ltd., and Pantwist, LLC, incorporated by reference from Exhibit 10.8 to Quarterly Report Form 10-QSB filed May 15, 2006.
10.44		Supplement No. 1 dated as of April 28, 2006 to the Guaranty Agreement dated as of November 29, 2005, by Pantwist, LLC in favor of Union Bank of California, as Administrative Agent, incorporated by reference from Exhibit 10.9 to Quarterly Report on Form 10-QSB filed May 15, 2006.
10.45		Supplement No. 1 dated as of April 28, 2006 to the Guaranty Agreement dated as of November 29, 2005, by Pantwist, LLC in favor of Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio, as Administrative Agent, incorporated by reference from Exhibit 10.10 to Quarterly Report on Form 10-QSB filed on May 15, 2006.
10.46		Supplement No. 1 dated as of April 28, 2006 to the Pledge Agreement dated as of November 29, 2005, by Cano Petroleum, Inc., W.O. Energy of Nevada, Inc. and WO Energy, Inc. in favor of Union Bank of California, N.A., as Collateral Trustee, incorporated by reference from Exhibit 10.11 to Quarterly Report Form 10-QSB filed on May 15, 2006.
10.47		Supplement No. 1 dated as of April 28, 2006 to the Security Agreement dated as of November 29, 2005, by Pantwist, LLC in favor of Union Bank of California, N.A., as Collateral Trustee, incorporated by reference from Exhibit 10.12 to Quarterly Report on Form 10-QSB filed on May 15, 2006.
10.48		Waiver from Union Bank of California, N.A. dated February 14, 2006 related to Credit Agreement dated as of November 29, 2005, incorporated by reference from Exhibit 10.13 to Quarterly Report on Form 10-QSB filed on May 15, 2006.
10.49		Waiver from Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio dated February 14, 2006 related to Subordinated Credit Agreement dated as of November 29, 2005, incorporated by reference from Exhibit 10.14 to Quarterly Report on Form 10-QSB filed on May 15, 2006.
10.50		Amendment No. 3 to Credit Agreement among Cano Petroleum, Inc., a Borrower, Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc. Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company, Ltd., Union Bank of California, N.A. and Natexis Banques Populaires dated May 12, 2006 and effective as of March 31, 2006, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on May 15, 2006.
10.51		Second Amendment to Subordinated Credit Agreement among Cano Petroleum, Inc., a Borrower, Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc. Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company, Ltd., Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio and UnionBanCal Equities, Inc. dated May 12, 2006 and effective as of March 31, 2006, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K

 

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		filed on May 15, 2006.
10.52+		Employment Agreement of Morris B. Smith effective June 1, 2006, incorporated by reference from Exhibit 10.1 on Current Report on Form 8-K filed on June 6, 2006.
10.53+		Second Amendment to Employment Agreement of James K. Teringo, Jr. effective June 1, 2006, incorporated by reference from Exhibit 10.2 in Current Report on Form 8-K filed on June 6, 2006.
10.54+		Second Amendment to Employment Agreement of John Lacik effective June 1, 2006, incorporated by reference from Exhibit 10.3 on Current Report on Form 8-K filed on June 6, 2006.
10.55+		Second Amendment to Employment Agreement of Michael J. Ricketts effective June 1, 2006, incorporated by reference from Exhibit 10.4 on Current Report on Form 8-K filed on June 6, 2006.
10.56+		Employee Restricted Stock Award Agreement of Morris B. Smith effective June 1, 2006, incorporated by reference from Exhibit 10.5 on Current Report Form 8-K filed on June 6, 2006.
10.57+		Employee Restricted Stock Award Agreement of James K. Teringo, Jr. effective June 1, 2006, incorporated by reference from Exhibit 10.6 on Current Report on Form 8-K filed on June 6, 2006.
10.58+		Employee Restricted Stock Award Agreement of John Lacik effective June 1, 2006, incorporated by reference from Exhibit 10.9 on Current Report Form 8-K filed on June 6, 2006.
10.59+		Employment Agreement of John Lacik effective May 1, 2005, incorporated by reference from Exhibit 10.8 on Current Report on Form 8-K filed on June 6, 2006.
10.60+		First Amendment to Employment Agreement of John Lacik effective May 1, 2005, incorporated by reference from Exhibit 10.9 on Form 8-K filed on June 6, 2006.
10.61		Amendment No. 4 to Credit Agreement among Cano Petroleum, Inc., as Borrower, Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc., Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company, Ltd., Union Bank of California, N.A. and Natexis Banques Populaires dated June 30, 2006, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on June 7, 2006.
10.62		Third Amendment to Subordinated Credit Agreement among Cano Petroleum, Inc., as Borrower, Square One Energy, Inc., Ladder Companies, Inc., W.O. Energy of Nevada, Inc., WO Energy, Inc., Pantwist, LLC, W.O. Operating Company, Ltd., W.O. Production Company, Ltd., Energy Components SPC EEP Energy Exploration and Production Segregated Portfolio and UnionBanCal Equities, Inc. dated June 30, 2006, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K filed on June 7, 2006.
10.63+		Employment Agreement of Michael J. Ricketts effective July 1, 2006, incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on August 17, 2006.
10.64+		Employee Restricted Stock Award Agreement of Morris B Smith dated August 11, 2006, incorporated by reference from Exhibit 10.2 to Current Report on Form 8-K filed on August 17, 2006.
10.65+		Stock Option Agreement of Patrick W. Tolbert dated August 11, 2006, incorporated by reference from Exhibit 10.3 to Current Report on Form 8-K filed on August 17, 2006.
10.66+		Stock Option Agreement of Dennis McCuistion dated August 11, 2006, incorporated by reference from Exhibit 10.4 to Current Report on Form 8-K filed on August 17, 2006.
10.67		Securities Purchase Agreement dated August 25, 2006 by and among Cano Petroleum, Inc. and the Buyers listed therein, incorporated by reference from Exhibit 10.1 to Amendment to Current Report on Form 8-K/A filed on August 31, 2006.
10.68		Form of Warrant to Purchase Common Stock dated September 6, 2006 by Cano Petroleum, Inc., incorporated by reference from Exhibit 10.1 to Current Report on Form 8-K filed on September 11, 2006.
16.1		Letter of Russell Bedford Stefanou Mirchandani LLP dated July 13, 2004, incorporated by reference from Exhibit 16.1 to Current Report on Form 8-K filed on July 15, 2004.
16.2		Letter of Hein & Associates LLP dated July 14, 2004, incorporated by reference from Exhibit 16.2 to Current Report on Form 8-K filed on July 15, 2004.
21.1		Subsidiaries of the Company, incorporated by reference from Exhibit 21.1 to Annual Report on Form 10-KSB filed on September 25, 2006.
23.1*		Consent of Hein & Associates LLP.
23.2*		Consent of Forrest A. Garb & Associates, Inc., Independent Petroleum Engineers.
31.1*		Certification by Chief Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.

 

21

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31.2*		Certification by Chief Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.
31.3*		Certification by Principal Accounting Officer, required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.
32.1*		Certification by Chief Executive Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.
32.2*		Certification by Chief Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.
33.3*		Certification of Principal Accounting Officer, required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.

 

*  Filed herewith

 +  Management contract or compensatory plan, contract or arrangement

22

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SIGNATURES

 

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this Form 10-KSB/A to be signed on its behalf by the undersigned, thereunto duly authorized.

 

23

INDEX TO FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM		F-2
CONSOLIDATED BALANCE SHEET		F-3
CONSOLIDATED STATEMENTS OF OPERATIONS		F-4
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY		F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS		F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS		F-7 – F-26

F-1

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Report of Independent Registered Public Accounting Firm

To the Board of Directors

Cano Petroleum, Inc.

Fort Worth, Texas

We have audited the consolidated balance sheet of Cano Petroleum, Inc. and subsidiaries as of June 30, 2006, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for the two years ended June 30, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cano Petroleum, Inc. and subsidiaries as of June 30, 2006, and the results of their operations and their cash flows for the two years ended June 30, 2006, in conformity with accounting principles generally accepted in the United States of America.

/s/ Hein & Associates LLP
Hein & Associates LLP
Dallas, Texas
September 8, 2006

F-2

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CANO PETROLEUM, INC.

CONSOLIDATED BALANCE SHEET
JUNE 30, 2006

ASSETS
Current assets
Cash and cash equivalents		$	644,659
Accounts receivable		3,563,649
Derivative assets		1,176,959
Prepaid expenses		205,349
Inventory		396,081
Other current assets		641,759
Total current assets		6,628,456
Oil and gas properties, successful efforts method		133,176,618
Less accumulated depletion and depreciation		(2,126,049		)
Net oil and gas properties		131,050,569
Fixed assets and other, net		6,778,055
Derivative assets		1,705,855
Goodwill		785,796
TOTAL ASSETS		$	146,948,731
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable		$	2,304,198
Oil and gas payable		1,399,047
Accrued liabilities		321,183
Taxes payable		419,692
Current portion of asset retirement obligations		19,809
Total current liabilities		4,463,929
Long-term liabilities
Long-term debt		68,750,000
Asset retirement obligations		1,587,569
Deferred tax liability		31,511,000
Total liabilities		106,312,498
Commitments and contingencies (Note 12)
Stockholders’ equity
Common stock, par value $.0001 per share; 50,000,000 authorized; 26,987,941 issued and 25,719,647 outstanding; including 2,644,192 shares held in escrow		2,685
Additional paid-in capital		53,054,699
Accumulated deficit		(11,850,419		)
Treasury stock, at cost; 1,268,294 shares held in escrow		(570,732		)
Total stockholders’ equity		40,636,233
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	146,948,731

 

See accompanying notes to these consolidated financial statements.

F-3

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CANO PETROLEUM, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

		Twelve Months Ended
		June 30,
		2006			2005
Operating Revenues:
Crude oil and natural gas sales		$	18,407,786		$	5,481,640
Operating Expenses:
Lease operating expenses		6,865,515			2,730,079
Production and ad valorem taxes		1,295,420			342,796
General and administrative, including stock compensation expense of $570,523 and $1,823,040, respectively		7,793,573			4,829,086
Accretion of asset retirement obligations		107,733			69,814
Depletion and depreciation		1,958,651			494,668
Total operating expenses		18,020,892			8,466,443
Income (loss) from operations		386,894			(2,984,803		)
Other income (expenses):
Unrealized loss on hedge contracts		(3,245,588		)	—
Interest expense		(2,608,197		)	—
Interest income and deductions, net		124,467			11,661
Total other income (expenses)		(5,729,318		)	11,661
Loss before income tax benefit		(5,342,424		)	(2,973,142		)
Deferred income tax benefit		3,498,000			—
Net loss		(1,844,424		)	(2,973,142		)
Preferred stock discount		—			416,534
Net loss applicable to common stock		$	(1,844,424	)	$	(3,389,676	)
Net loss per share - basic and diluted		$	(0.08	)	$	(0.29	)
Weighted average common shares outstanding
Basic and diluted		22,364,099			11,839,080

 

See accompanying notes to these consolidated financial statements.

F-4

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CANO PETROLEUM, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

JUNE 30, 2004 THROUGH JUNE 30, 2006

																	Additional
		Series B					Series C					Common Stock					Paid-in			Accumulated			Deferred			Treasury Stock
		Shares		Amount			Shares		Amount			Shares		Amount			Capital			Deficit			Compensation			Shares			Amount			Total
Balance at June 30, 2004		2,000		$	1,865,894		1,400		$	1,265,894		15,647,204		$	1,565		$	8,643,137		$	(6,616,319	)	$	(2,227,406	)	—			$	—		$	2,932,765
Net proceeds from issuance of Series C Preferred Stock		—		(5,044		)	5,350		5,344,916			—		—			(2,365		)	—			—						—			5,337,507
Preferred Series B & C shares converted to common shares during March 2005		(2,000	)	(1,860,850		)	(6,750	)	(6,610,810		)	2,466,665		247			8,471,413			—			—						—			—
Preferred stock dividend from beneficial conversion feature		—		—			—		—			—		—			416,534			(416,534		)	—						—			—
Net proceeds from issuance of common shares		—		—			—		—			1,350,000		135			4,750,648			—			—						—			4,750,783
Issuance of common shares for Square One Energy acquisition		—		—			—		—			888,888		89			3,519,907			—			—						—			3,519,996
Stock based compensation		—		—			—		—			—		—			144,255			—			—						—			144,255
Management shares returned to treasury stock		—		—			—		—			(15,783	)	—			—			—			7,102			15,783			(7,102		)	—
Amortization of deferred compensation		—		—			—		—			—		—			—			—			1,678,785			—			—			1,678,785
Net loss		—		—			—		—			—		—			—			(2,973,142		)	—			—			—			(2,973,142		)
Balance at June 30, 2005		—		$	—		—		$	—		20,336,974		$	2,036		$	25,943,529		$	(10,005,995	)	$	(541,519	)	15,783			$	(7,102	)	$	15,390,949
Net proceeds and assets from issuance of common shares		—		—			—		—			4,703,864		$	470		$	18,278,536		$	—		$	—		$	—		$	—		$	18,279,006
Issuance of common shares for WO Energy acquisition		—		—			—		—			1,791,320		$	179		$	8,240,000		$	—		$	—		$	—		$	—		8,240,179
Stock based compensation		—		—			—		—			140,000		—			592,634			—			(22,111		)				—			570,523
Escrow shares returned to Treasury		—		—			—		—			—		—			—			—			563,630			1,252,511			$	(563,630	)	—
Net loss		—		—			—		—			—		—			—			(1,844,424		)	—			—			—			(1,844,424		)
Balance at June 30, 2006		—		$	—		—		$	—		26,972,158		$	2,685		$	53,054,699		$	(11,850,419	)	$	0		1,268,294			$	(570,732	)	$	40,636,233

 

See accompanying notes to these consolidated financial statements.

F-5

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CANO PETROLEUM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

		Twelve Months Ended June 30,
		2006			2005
Cash flow from operating activities:
Net loss		$	(1,844,424	)	$	(2,973,142	)
Adjustments needed to reconcile to net cash flow used in operations:
Loss on hedge contracts		3,245,588			—
Accretion of asset retirement obligations		107,733			69,814
Depletion and depreciation		1,958,651			494,668
Stock compensation expense		570,523			1,823,040
Deferred income tax benefit		(3,498,000		)	—
Other amortization		656,382			—
Changes in assets and liabilities relating to operations:
Derivative assets		(6,128,402		)	—
Accounts receivable		(971,715		)	(489,893		)
Inventory		(276,904		)	—
Accounts payable		1,790,631			670,116
Accrued liabilities		(393,264		)	(74,569		)
Other current assets and liabilities		(1,300,573		)	(21,069		)
Net cash used in operations		(6,083,774		)	(501,035		)
Cash flow from investing activities:
Additions to oil and gas properties		(5,699,133		)	(1,646,160		)
Additions to fixed assets and other		(133,318		)	(464,477		)
Acquisition of W.O. Energy of Nevada, Inc.		(48,426,688		)	—
Acquisition of additional Davenport revenue interest		(700,350		)	(667,000		)
Acquisition by Pantwist, LLC.		(23,405,865		)	—
Acquisition of Nowata		—			(2,561,880		)
Acquisition of Square One Energy, Inc.		—			(4,037,535		)
Acquisition of Ladder		—			(2,215,467		)
Cash restricted for development activities		—			866,339
Net cash used in investing activities		(78,365,354		)	(10,726,180		)
Cash flow from financing activities:
Net proceeds from long-term debt		67,323,874			—
Payments for debt-issuance costs		(654,582		)	(54,589		)
Proceeds from issuance of preferred stock, net		—			5,101,231
Proceeds from issuance of common stock, net		18,279,006			4,750,783
Net cash from financing activities		84,948,298			9,797,425
Net increase (decrease) in cash and cash equivalents		499,170			(1,429,790		)
Cash and cash equivalents at beginning of period		145,489			1,575,279
Cash and cash equivalents at end of period		$	644,659		$	145,489
Supplemental disclosure of noncash transactions:
Preferred stock discount		—			$	416,534
Common stock issued for acquisition of Square One Energy, Inc.		—			$	3,519,996
Common stock issued for acquisition of W.O. Energy of Nevada, Inc.		$	8,240,179		—
Recognition of deferred tax liability for Square One Energy, Inc.		$	3,124,013		—
Supplemental disclosure of cash transactions:
Cash paid during the period for interest		$	2,303,375		—

 

See accompanying notes to these consolidated financial statements.

F-6

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CANO PETROLEUM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.     ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cano Petroleum, Inc. is a growing independent oil and natural gas company, based in Fort Worth, Texas, that is actively pursuing waterflooding and 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 were originally organized under the laws of the State of Delaware on May 29, 2003 as Huron Ventures, Inc. Cano was involved in the merger of Huron Ventures, Inc. (“Huron”) and several entities, including the Davenport Field Unit (“Davenport”), on May 28, 2004. Effective with the merger, Huron changed its name to Cano Petroleum, Inc. The merger is discussed in greater detail in Note 2.

Our wholly-owned subsidiaries consist of Ladder Companies, Inc., a Delaware corporation; Square One Energy, Inc., a Texas corporation; W.O. Energy of Nevada, Inc. (“W.O. Energy), a Nevada corporation; and Pantwist, LLC, a Texas limited liability corporation. Ladder Companies, Inc. wholly owns Tri-Flow, Inc., an Oklahoma corporation. There is no significant business transacted through Tri-Flow. W.O. Energy wholly owns W.O. Energy, Inc. (“WO Texas”), a Texas corporation. WO Energy and WO Texas wholly own W.O. Operating Company, Ltd. and W.O. Production Company, Ltd, both of which are Texas limited partnerships.

Consolidation and Use of Estimates

The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of Cano and its wholly-owned subsidiaries. Intercompany accounts and transactions are eliminated. In preparing the accompanying financial statements, management has made certain estimates and assumptions that affect reported amounts in the financial statements and disclosures of contingencies. Actual results may differ from those estimates. Significant assumptions are required in the valuation of proved oil and natural gas reserves, which may affect the amount at which oil and natural gas properties are recorded. It is at least reasonably possible these estimates could be revised in the near term, and these revisions could be material.

Oil and Gas Properties and Equipment

We follow the successful efforts method of accounting, capitalizing costs of successful exploratory wells and expensing costs of unsuccessful exploratory wells. All developmental costs are capitalized. We are predominately engaged in the acquisition and development of proved reserves as opposed to exploration activities. The property costs reflected in the accompanying balance sheet were acquired in the merger and subsequent acquisitions, as discussed in Notes 2 and 3. Cano had capitalized costs for its oil and natural gas properties of $133,176,618 at June 30, 2006.

Depreciation and depletion of producing properties is computed on the units-of-production method based on estimated proved oil and natural gas reserves. Repairs and maintenance are expensed, while renewals and betterments are generally capitalized.

Our units-of-production amortization rates are revised on a quarterly basis. Our development costs and lease and wellhead equipment are depleted based on proved developed reserves. Our leasehold costs are depleted based on total proved reserves.

At least quarterly, or more frequently if conditions indicate that long-term assets may be impaired, the carrying value of property is compared to management’s future estimated pre-tax cash flow from the properties. In accordance with Statement of Financial Accounting Standards No. 144, Accounting

F-7

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for Impairment or Disposal Of Long-Lived Assets, if impairment is necessary, the asset carrying value is written down to fair value. Cash flow pricing estimates are based on existing proved reserve and production information and pricing assumptions that management believes are reasonable. Impairment of individually significant unproved properties is assessed on a property-by-property basis, and impairment of other unproved properties is assessed and amortized on an aggregate basis. We had no significant unproved properties at June 30, 2006. No impairment was necessary at June 30, 2006.

Asset Retirement Obligation

Our financial statements reflect the provisions of Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 provides that, if the fair value for an asset retirement obligation can be reasonably estimated, the liability should be recognized upon acquiring or drilling a well. Under the method prescribed by SFAS No. 143, the retirement obligation is recorded as a liability at its estimated present value at the asset’s inception, with an offsetting increase to producing properties on the balance sheet. Periodic accretion of the discount of the estimated liability is recorded as an expense in the statement of operations.

Goodwill

The amount paid for the transaction described in Notes 2 and 11 in excess of the fair value of the net assets acquired has been recorded as “Goodwill” in the Consolidated Balance Sheet. Goodwill is not amortized, but is assessed for impairment annually or whenever conditions would indicate impairment may exist. There were no impairments recorded in either of the fiscal years ended June 30, 2005 and 2006.

Cash and Cash Equivalents

Cash equivalents are considered to be all highly liquid investments having an original maturity of three months or less. Excess cash funds are generally invested in U.S. government-backed securities.

Accounts Receivable

Accounts receivable principally consists of crude oil and natural gas sales proceeds receivable, typically due within 35 days of crude oil and natural gas production, respectively. We require no collateral for such receivables, nor do we charge interest on past due balances. We periodically review receivables for collectibility and reduce the carrying amount of the receivables by an allowance. No such allowance was indicated at June 30, 2006. As of June 30, 2006, our accounts receivable were primarily held by several independent purchasers of our crude oil and natural gas production. At June 30, 2006, we had balances due from four customers which were greater than 10% of our accounts receivable related to crude oil and natural gas production. These four customers had 29%, 24%, 14% and 12% of accounts receivable related to crude oil and natural gas production, respectively.

Revenue Recognition

We recognize revenue when crude oil and natural gas quantities are delivered to or collected by the respective purchaser. Title to the produced quantities transfers to the purchaser at the time the purchaser collects or receives the quantities. Prices for such production are defined in sales contracts and are readily determinable based on certain publicly available indices. The purchasers of such production have historically made payment for crude oil and natural gas purchases within thirty-five days of the end of each production month. We periodically review the difference between the dates of production and the dates we collect payment for such production to ensure that receivables from those purchasers are collectible. The point of sale for our oil and natural gas production is at our applicable field gathering system; therefore, we do not incur transportation costs related to our sales of oil and natural gas production.

F-8

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As of June 30, 2005 and 2006, we sold our crude oil and natural gas production to several independent purchasers. During the twelve months ended June 30, 2005, we had sales to primarily three customers which represented 58%, 21% and 19% of total operating revenue, respectively. During the twelve months ended June 30, 2006, we had sales of 10% or more of our total revenues to five customers representing 29%, 25%, 12%, 12% and 10% of total operating revenue, respectively.

Income Taxes

We began our oil and natural gas operations on May 28, 2004. Since, for the twelve month period ended June 30, 2005, we had incurred a net loss and had not yet generated book or tax income, our consolidated statement of operations through June 30, 2005 did not reflect a provision for income taxes.

We began to record income taxes in the quarter ended December 31, 2005 as a result of the acquisition of WO Energy. This is more fully discussed in Note 11.

Deferred tax assets or liabilities are recognized for the anticipated future tax effects of temporary differences between the financial statement basis and the tax basis of the Company’s assets and liabilities. These balances are measured using tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance for deferred tax assets is recorded when it is more likely than not that the benefit from the deferred tax asset will not be realized.

Financial Instruments

The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value, unless otherwise stated, as of June 30, 2006. The carrying amount of long-term debt approximates market value due to the use of market interest rates.

Net Loss per Common Share

Basic net 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 loss per common share is computed in the same manner, but also considers the effect of the stock options plans totaling 532,185 shares and 175,000 shares at June 30, 2006 and 2005, respectively (as discussed in Note 8).

The weighted average shares used in the basic net income (loss) per common share computations for June 30, 2006 and 2005 were 22,364,099 shares and 11,839,080 shares, respectively. These share amounts at June 30, 2006 and 2005 exclude contingently issuable shares of 2,659,975 and 5,165,000 shares issued to Cano employees that are held in escrow or treasury as discussed in Note 9 and the previously discussed stock option plan shares and contingently issued shares.

At June 30, 2006 and 2005, the previously discussed stock option plan shares and contingently issued shares were anti-dilutive and, therefore, are not included in the loss per share calculation for either year.

Stock Compensation Expense

We account for share-based payments for services provided by employee to employer in accordance with Statement of Financial Accounting Standard No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation. SFAS 123 requires companies to expense the fair value of employee stock options and other equity-based compensation at the grant date. Effective July 1, 2006, we intend adopt SFAS No. 123(R).

F-9

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Derivative Hedging Contracts

We are required to enter into financial contracts to hedge a portion of our production at specified prices for oil and natural gas. The objective of the hedging contracts is to reduce our exposure to commodity price risk associated with expected oil and natural gas production. We have purchased hedging contracts that set “price floors” for our crude oil and natural gas production.

We have no derivative hedging contracts that set a price ceiling. We do not designate our derivatives as cash flow or fair value hedges. We do not hold or issue derivative financial instruments for speculative or trading purposes. We are exposed to credit losses in the event of nonperformance by the counterparties to our financial hedging contracts. We anticipate, however, that our counterparty, Union Bank of California, will be able to fully satisfy their obligations under the contracts. We do not obtain collateral or other security to support our financial hedging contracts subject to credit risk but we monitor the credit standing of the counterparties.

We have elected not to designate the derivative financial instruments to which we are a party as hedges, and accordingly, we record such contracts at fair value and recognize changes in such fair value in current earnings as they occur.

New Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment.” SFAS No. 123(R) revises SFAS No. 123, “Accounting for Stock-Based Compensation,” and focuses on accounting for share-based payments for services provided by employee to employer. The statement requires companies to expense the fair value of employee stock options and other equity-based compensation at the grant date. The statement does not require a certain type of valuation model, and either a binomial or Black-Scholes model may be used.  We intend to adopt this SFAS 123(R) beginning July 1, 2006.  Since we currently expense stock options granted to employees in accordance with SFAS 121, management does not believe that the adoption of SFAS No. 123(R) will materially impact our operating results, financial position, or our future cash flows.

On July 13, 2006, the FASB released FIN 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109.”  FIN 48 requires companies to evaluate and disclose material uncertain tax positions it has taken with various taxing jurisdictions.  We are currently reviewing FIN 48 and are unable to determine the effect, if any, that FIN 48 will have to our operating results, financial position, or future cash flows.

2. MERGER

On May 28, 2004, we entered into an Agreement and Plan of Merger with our wholly owned subsidiary, Davenport Acquisition Corp., an Oklahoma corporation; Davenport Field Unit, Inc., a Texas corporation; the shareholders of Davenport Field Unit; Cano Energy Corporation, a Texas corporation; and Big Sky Management Ltd., our then principal stockholder. Our CEO, S. Jeffrey Johnson, is a principal shareholder in Cano Energy Corporation (now THEprivate Energy Company, Inc.).

The Davenport Field Unit’s sole asset consisted of 100% working interest in certain oil, natural gas and mineral leasehold estates and personal property related to such leasehold estates located in Lincoln County, Oklahoma covering approximately 2,178 acres. Under the terms of the merger, we issued 5,165,000 shares of our common stock to the former shareholders of the Davenport Field Unit and paid $1,650,000 to fund developmental costs associated with the Davenport Field Unit and assumed debt. Pursuant to the terms of the merger, we changed our name to Cano Petroleum, Inc. on June 3, 2004.

The 5,165,000 shares issued to the Davenport Field Unit shareholders are further discussed in Note 9.

The merger transaction was recorded on the purchase method of accounting. The purchase price was allocated to the acquired assets and assumed liabilities based on their fair values, and the unallocated amount of $101,166 was recorded as goodwill, all of which is deductible for income tax purposes. The fair value assigned to the oil and natural gas properties is based on management’s valuation of the properties, which was derived in part by reference to a reserve report prepared by an independent petroleum engineering firm. Based on the engineer’s report and Cano’s internal analysis, we believe the Davenport field has unrealized potential to support the recording of “Goodwill” to the Consolidated Balance Sheet.

3. ACQUISITIONS

W.O Energy of Nevada, Inc. - On November 29, 2005, we acquired all of the outstanding common stock of WO Energy for approximately $57.5 million, after purchase price adjustments. The purchase price consisted of approximately $48.4 million in cash (net of cash acquired) and approximately $8.24 million in restricted shares of our common stock. $2 million of the cash portion of the purchase price was paid into an escrow account to be kept for a minimum of two years to cover potential indemnification payments by the sellers. The approximate $8.24 million of common stock resulted in

F-10