UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the transition period from                  to                  

Commission file number 001-32496

CANO PETROLEUM, INC.

(Exact name of registrant as specified in its charter)

The Burnett Plaza

801 Cherry Street, Suite 3200

Fort Worth, TX 76102

(Address of principal executive offices including zip code)

(817) 698-0900

(Registrant’s telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 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

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

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 the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:  46,078,518 shares of common stock, $.0001 par value per share, as of November 6, 2008.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

CANO PETROLEUM, INC.
CONSOLIDATED BALANCE SHEETS

(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
JULY 1, 2008 THROUGH SEPTEMBER 30, 2008
(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to these unaudited financial statements.

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CANO PETROLEUM, INC.

NOTES TO FINANCIAL STATEMENTS

1.   BASIS OF PRESENTATION AND USE OF ESTIMATES

The interim consolidated financial statements of Cano Petroleum, Inc. are unaudited and contain all adjustments (consisting primarily of normal recurring accruals) necessary for a fair statement of the results for the interim periods presented. Results for interim periods are not necessarily indicative of results to be expected for a full year due in part, but not limited to, the volatility in prices for crude oil and natural gas, future commodity prices for commodity derivatives, 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 these consolidated interim financial statements in conjunction with the audited consolidated financial statements and notes thereto included in our Form 10-K for the year ended June 30, 2008.

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. The computation of stock based compensation expense requires assumptions such as volatility, expected life and the risk-free interest rate. It is at least reasonably possible these estimates could be revised in the near term, and these revisions could be material.

Pro Forma Financial Information

We have presented unaudited pro forma financial information on our consolidated balance sheets and consolidated statements of operations, as of and for the three months ended September 30, 2008, to present the effects of the sale of Pantwist, LLC for  $40.1 million, ($42.7 million including $2.0 million of cash received from discontinued operating income and $0.6 million of broker fees) which was completed on October 1, 2008.  The pro forma consolidated balance sheet as of September 30, 2008 reflects the sale as if it had occurred on September 30, 2008.  The pro forma consolidated statement of operations for the three months ended September 30, 2008 reflects the sale as if it had occurred on July 1, 2008.  This is further discussed under Note 2.

New Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115 (“SFAS No. 159”). SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. It provides entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We have adopted SFAS No. 159 on July 1, 2008. The adoption of SFAS No. 159 did not have a material impact on our financial position, results of operations or cash flows.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141R”). Among other things, SFAS No. 141R establishes principles and requirements for how the acquirer in a business combination (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquired business, (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. This standard will change our accounting treatment for business combinations on a prospective basis.

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In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51 (“SFAS No. 160”). SFAS No. 160 establishes accounting and reporting standards for noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. Minority interests will be recharacterized as noncontrolling interests and classified as a component of equity. It also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary and requires expanded disclosures. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. We will adopt SFAS No. 161 on July 1, 2009. We do not expect the adoption of this statement will have a material impact on our financial position, results of operations or cash flows.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities—An Amendment of FASB Statement 133 (“SFAS No. 161”). SFAS No. 161 amends and expands SFAS No. 133 to enhance required disclosures regarding derivatives and hedging activities. It requires companies to provide additional disclosure to discuss the uses of derivative instruments; the accounting for derivative instruments and related hedged items under SFAS No. 133; and how derivative instruments and related hedged items affect the company’s financial position, financial performance and cash flows. We will adopt SFAS No. 161 on July 1, 2009. We do not expect the adoption of this statement will have a material impact on our financial position, results of operations or cash flows.

 2.   DISCONTINUED OPERATIONS

On October 1, 2008, we sold our wholly-owned subsidiary, Pantwist, LLC, for $40.1 million ($42.7 million including $2.0 million of cash received from discontinued operating income and $0.6 million of broker fees).  The sale had an effective date of July 1, 2008.  There are certain post-closing adjustments that are to be finalized between the parties within 90 days of October 1, 2008.  We do not anticipate that post-closing adjustments will be material in amount.  We anticipate recording a pre-tax gain on the sale of approximately $19.4 million ($12.3 million after-tax), and any current tax liabilities relating to such gain will be fully offset by existing net operating losses. We used the entire $42.7 million net cash proceeds received from the transaction and cash on hand to pay down amounts outstanding under the senior credit agreement on October 1, 2008 (as discussed in Note 4).

On September 8, 2008, the buyer paid a $2.1 million deposit toward the purchase of Pantwist, LLC which was included within the $40.1 million purchase on the October 1, 2008 closing date.  Between July 1, 2008 (effective date of the sale) and September 30, 2008, the net operating income from Pantwist operations amounted to $2.2 million pre-tax ($1.4 million after-tax).

At September 30 and June 30, 2008, the assets of Pantwist, LLC are classified as assets held for sale and the liabilities are classified as liabilities associated with discontinued operations on the consolidated balance sheets.  At September 30, 2008 and June 30, 2008, the reclassified net book value of $20.7 million and $20.8 million, respectively, primarily represents the oil and gas properties (net) and is shown at its carrying amount, which is lower than the fair value at September 30, 2008.  The operating results of Pantwist, LLC for the three months ended September 30, 2008 and 2007 have been reclassified as discontinued operations in the consolidated statements of operations as detailed in the table below.

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The pro forma balance sheet presented as part of our consolidated balance sheets reflects the sale of “assets held for sale”; gain on sale of Pantwist, LLC (net of related income taxes); and application of cash transaction proceeds received on October 1, 2008 totaling $42.7 million to paydown long-term debt. We incurred $0.6 million of fees associated with the sale. Accordingly, long-term debt is fully repaid to a zero balance at September 30, 2008.  The consolidated pro forma balance sheet reflects the sale as if it had occurred on September 30, 2008.

The pro forma statement of operations information presented with our consolidated statement of operations reflects the gain on sale of Pantwist, LLC (net of related taxes) as if it had occurred on July 1, 2008.

 3.   COMMON STOCK ISSUANCE

On July 1, 2008, we completed the sale of 7,000,000 shares of our common stock through an underwritten offering at a share price of $8.00 per share ($7.75 net to us) resulting in net proceeds of approximately $53.9 million after underwriting discounts and commissions and expenses.

We used the net proceeds from the offering to pay down debt which will subsequently be drawn in order to finance (i) existing development activities in certain core areas such as the Panhandle and Cato properties, (ii) selective acquisitions and (iii) general corporate purposes.

 4.   LONG-TERM DEBT

At September 30, 2008 and June 30, 2008, the outstanding amount due under the credit agreements was $42.7 million and $73.5 million, respectively.

On September 30, 2008, we borrowed such amounts necessary under the senior credit agreement to pay off the entire outstanding $15.0 million principal due under our subordinated credit agreement, interest expense and a prepayment premium of $0.3 million.  In conjunction with the payoff, we terminated the subordinated credit agreement.  The outstanding balance under the subordinated credit agreement had an interest rate of 8.50%.

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As of September 30, 2008, the senior credit agreement is our only current source of borrowing and the average interest rate was 5.19%.  At September 30, 2008, we were in compliance with the senior credit agreement debt covenants.

On October 1, 2008, we repaid all outstanding principal and interest under the senior credit agreement with the proceeds from the sale of Pantwist, LLC, as discussed in Note 2, and other available cash.  As of October 1, 2008, our available borrowing base under the senior credit agreement remains at $60.0 million after consideration for the sale of Pantwist, LLC. We expect to draw down on the senior credit agreement in order to subsequently finance (i) existing development activities in certain core areas such as the Panhandle and Cato properties, (ii) selective acquisitions and (iii) general corporate purposes.

 5.   COMMODITY DERIVATIVES

Pursuant to our senior credit agreement discussed in Note 4, we are required to enter into commodity derivative contracts to mitigate price risk on at least 50% and no greater than 85% of our crude oil and natural gas production volumes attributable to proved producing reserves, for at least three years as of the end of each six month period ending thereafter.

As of September 30, 2008, we maintain the following “costless collar” financial contracts:

As of September 30, 2008, we maintain the following financial “floor price” contracts:

During October 2008, we sold the “floor price” contracts covering July 2010 to December 2010 for $0.6 million to our counterparty, and had a realized gain of $0.1 million. All currently remaining commodity derivative contracts are with Union Bank of California, N.A., our administrative agent for our credit agreement.

The total volumes covered by costless collars and price floors detailed in the above tables is greater than 85% of our crude oil and natural gas production volumes attributable to proved developed producing reserves through December 2010; however, the lenders under our senior credit agreement have approved all commodity derivative contracts.

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During the three months ended September 30, 2008 and 2007, there were settlements under our commodity derivatives, due to us and paid by us, that are accrued as realized gains or losses on commodity derivatives in our consolidated statements of operations that are summarized as follows:

The cash settlements received by us were cumulative monthly payments due to us since the NYMEX natural gas and crude oil prices were lower than the “floor prices” set for the respective time period. The cash settlements paid/accrued by us were cumulative monthly payments due to our counterparty since the NYMEX crude oil and/or natural gas prices were higher than the “ceiling prices” set for the respective time period. The cash flows relating to the derivative instrument settlements that are due, but not cash settled are reflected in operating activities on our consolidated statements of cash flows. At September 30, 2008, we had no amounts due from or payable to our counterparty. At September 30, 2007, we had $0.1 million due from our counterparty included in accounts receivable on our consolidated balance sheet.

We computed our mark-to-market valuations used for our commodity derivatives based on assumptions regarding forward prices, volatility and the time value of money as discussed in Note 10. We compared our valuations to our counterparties’ valuations to further validate our mark-to-market valuations. During the three months ended September 30, 2008, we recognized an unrealized gain on commodity derivatives in our consolidated statements of operations amounting to $24.2 million as compared to an unrealized loss of $0.5 million for the three months ended September 30, 2007.

As of September 30, 2008, we had aggregate derivative assets and liabilities of $1.5 million and $3.7 million, respectively.  These amounts are based on our mark-to-market valuations of our derivative commodities at September 30, 2008 and may not be indicative of actual future settlements.

 6.   DEFERRED COMPENSATION

As of September 30, 2008, we have non-vested restricted shares totaling 656,667 shares to key employees pursuant to our 2005 Long-Term Incentive Plan, as summarized below:

The restricted share grants will vest to the employees based on future years of service ranging from one to three years depending on the life of the award agreement.  The fair value is based on our actual stock price on the date of grant multiplied by the number of restricted shares granted.  As of September 30, 2008, the value of non-vested restricted shares amounted to $4.6 million.  For the quarters ended September 30, 2008 and 2007, we have expensed $0.8 million and $0.4 million, respectively, to stock compensation expense based on amortizing the fair value over the appropriate service period.  The forfeitures resulted from shares used to satisfy employees’ tax withholding obligations related to the vesting of their restricted shares and the retirement of a key employee, which resulted in the forfeiture of unvested restricted shares.

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 7.   STOCK OPTIONS

For the quarter ended September 30, 2008, we granted 231,850 stock options to non-executive employees from our 2005 Long-Term Incentive Plan.  The options were granted with an exercise price equal to our market price at the date of grant and have ten-year contractual terms.  These stock option awards vest over six months to three years of continuous service.  The factors used to calculate the fair value of these options are summarized in the table below.

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model. Expected volatility is based on the historical volatility of our common stock. We use historical data to estimate option exercise and employee termination within the valuation model. The expected lives of options granted represent the period of time that options granted are expected to be outstanding. The risk-free interest rate for periods within the contractual life of the option is based on the five-year U.S. Treasury yield curve in effect at the time of the respective grant. The expected dividend yield reflects our intent not to pay dividends on our common stock during the contractual periods.

A summary of outstanding options as of September 30, 2008 is as follows:

Based on our $2.31 stock price at September 30, 2008, there was no intrinsic value of the options outstanding and exercisable.

Total options exercisable at September 30, 2008 amounted to 561,803 shares and had a weighted average exercise price of $5.75.  At September 30, 2007, total options exercisable amounted to 275,000 shares and had a weighted average exercise price of $5.21.  Upon exercise, we issue the full amount of shares exercisable per the term of the options from new shares. We have no plans to repurchase those shares in the future.

For each of the quarters ended September 30, 2008 and 2007, we recorded charges to stock compensation expense of $0.2 million for the estimated fair value of the options granted to our directors and employees.

 8.   NET INCOME (LOSS) PER COMMON SHARE

Basic net income (loss) per common share is computed by dividing the net income (loss) attributable to common shareholders by the weighted average number of shares of common stock outstanding less unvested restricted shares during the period.  Diluted net income (loss) per common share is computed in the same manner, but also considers the effect of common stock shares underlying stock options, the preferred stock, paid-in-kind (“PIK”) dividends and unvested restricted stock.

The following table reconciles earnings and shares used in the computation of basic and diluted earnings per share for the three months ended September 30, 2008:

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As of September 30, 2007, shares of common stock underlying the following items summarized below were not included in the weighted average shares outstanding for the three months ended September 30, 2007 as their effects would have been anti-dilutive.

 9.   RELATED PARTY TRANSACTIONS

Pursuant to an agreement dated December 16, 2004, as amended, we agreed with R.C. Boyd Enterprises, a Delaware corporation, to become the lead sponsor of a television production called Honey Hole (“Honey Hole Production”). As part of our sponsorship, we are able to provide fishing and outdoor opportunities for children with cancer, children from abusive family situations and children of military veterans. For the three months ended September 30, 2008 and 2007, we paid $37,500 for each quarter to R.C. Boyd Enterprises, the owner of Honey Hole All Outdoors. Randall Boyd is the sole shareholder of R.C. Boyd Enterprises and is a member of our Board of Directors. Pursuant to a new agreement dated as of December 5, 2007, after December 31, 2008, we will no longer be a Honey Hole Production sponsor. Our remaining commitment is $37,500 through December 31, 2008. We are entitled to receive two thirty-second commercials during all broadcasts of the Honey Hole Production and receive opening and closing credits on each episode.

10.   FAIR VALUE MEASUREMENTS

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, (“SFAS No. 157”) was issued by the FASB in September 2006. SFAS No. 157 defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurement. We adopted SFAS No. 157 on July 1, 2008.  The initial adoption of SFAS 157 had no material impact to our financial position, results of operations or cash flows.

Fair value is the price that would be received to sell an asset or the amount paid to transfer a liability in an orderly transaction between market participants (an exit price) at the measurement date. Fair value is a market based measurement considered from the perspective of a market participant. We use market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation. These inputs can be readily observable, market corroborated, or unobservable. If observable prices or inputs are not available, unobservable prices or inputs are used to estimate the current fair value, often using an internal valuation model. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the item being valued.  We primarily apply a market approach for recurring fair value measurements using the best available information while utilizing valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.  Our valuation includes the effect of potential non-performance by the counterparties.

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Beginning July 1, 2008, assets and liabilities recorded at fair value are categorized based upon the level of judgment associated with the inputs used to measure their fair value.  SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). We classify fair value balances based on the observability of those inputs. The three levels of the fair value hierarchy are as follows:

Level 1—Quoted prices in active markets for identical assets or liabilities that we have the ability to access. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2—Inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable. These inputs are either directly observable in the marketplace or indirectly observable through corroboration with market data for substantially the full contractual term of the asset or liability being measured.

Level 3—Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

In valuing certain contracts, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. For disclosure purposes, assets and liabilities are classified in their entirety in the fair value hierarchy level based on the lowest level of input that is significant to the overall fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the placement within the fair value hierarchy levels.

The fair value of our derivative contracts are measured using Level 2 and Level 3 inputs.  The derivative assets and liabilities were classified as Level 3 due to the subjectivity of our valuation for the effect of our own credit risk.

Our asset retirement obligation is measured using primarily Level 3 inputs. The significant unobservable inputs to this fair value measurement include estimates of plugging, abandonment and remediation costs, inflation rate and well life. The inputs are calculated based on historical data as well as current estimated costs.

The estimated fair values of derivatives included in the consolidated balance sheet at September 30, 2008 are summarized below. The decrease in the current and noncurrent derivative liabilities from June 30, 2008 to September 30, 2008 is primarily attributable to the effect of lower crude oil and natural gas prices.

The following table shows the reconciliation of changes in the fair value of the net derivative liability and asset retirement obligation classified as Level 3 in the fair value hierarchy for the quarter ended September 30, 2008.

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11.   IMPAIRMENT OF LONG-LIVED ASSET

In light of current commodity prices and our revised drilling capital budget, we believe there is uncertainty in the likelihood of our developing Corsicana’s proved undeveloped reserves within the next five years.  Therefore, we have recorded a pre-tax $3.5 million impairment on our Corsicana oil and gas properties.  Fair value was determined using estimates of future net cash flows, discounted to a present value.

12.   COMMITMENTS AND CONTINGENCIES

Burnett Case

On March 23, 2006, the following lawsuit was filed in the 100th Judicial District Court in Carson County, Texas; Cause No. 9840, The Tom L. and Anne Burnett Trust, by Anne Burnett Windfohr, Windi Phillips, Ben Fortson, Jr., George Beggs, III and Ed Hudson, Jr. as Co-Trustees; Anne Burnett Windfohr; and Burnett Ranches, Ltd. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc. The plaintiffs claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and natural gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas.

The plaintiffs (i) allege negligence and gross negligence and (ii) seek damages, including, but not limited to, damages for damage to their land and livestock, certain expenses related to fighting the fire and certain remedial expenses totaling approximately $1.7 million to $1.8 million. In addition, the plaintiffs seek (i) termination of certain oil and natural gas leases, (ii) reimbursement for their attorney’s fees (in the amount of at least $549,000) and (iii) exemplary damages. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or a general partnership or de facto partnership. The owner of the remainder of the mineral estate, Texas Christian University, intervened in the suit on August 18, 2006, joining Plaintiffs’ request to terminate certain oil and gas leases.

On June 21, 2007, the Judge of the 100^th Judicial District Court issued a Final Judgment (a) granting motions for summary judgment in favor of Cano and certain of its subsidiaries on plaintiffs’ claims for (i) breach of contract/termination of an oil and gas lease; and (ii) negligence; and (b) granting the plaintiffs’ no-evidence motion for summary judgment on contributory negligence, assumption of risk, repudiation and estoppel affirmative defenses asserted by Cano and certain of its subsidiaries. The Final Judgment has been appealed.

Other Cases

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

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Nevada, Inc., W. O. Operating Company, Ltd. and WO Energy, Inc. (“Adcock”). The plaintiffs claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The plaintiffs (i) allege negligence, res ipsa loquitor, trespass and nuisance and (ii) seek damages, including, but not limited to, damages to their land, buildings and livestock and certain remedial expenses totaling $5,439,958. In addition, the plaintiffs seek (i) reimbursement for their attorney’s fees and (ii) exemplary damages. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or a general partnership or de facto partnership. By Settlement Agreement and Release signed by all parties by November 5, 2008, the claims of all plaintiffs in this suit were resolved and will be dismissed with prejudice.  This Settlement Agreement and Release does not affect the claims of any Intervenors in this matter, except those of Abraham Brothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abraham and Jason M. Abraham.

On July 6, 2006, Anna McMordie Henry and Joni McMordie Middleton intervened in the Adcock case. The intervenors (i) allege negligence and (ii) seek damages totaling $64,357 as well as exemplary damages.

On July 20, 2006, Abraham Brothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abraham and Jason M. Abraham intervened in the Adcock case. The intervenors (i) allege negligence, nuisance, and trespass and (ii) seek damages, including, but not limited to, damages to their land, buildings and livestock and certain remedial expenses totaling $3,252,862. In addition, the intervenors seek (i) reimbursement for their attorney’s fees and (ii) exemplary damages. The intervenors also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or a general partnership or de facto partnership. The claims of Abraham Brothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abraham and Jason M. Abraham (along with those asserted by Abraham Equine, Inc. discussed below) were resolved through a Settlement Agreement and Release effective October 12, 2008 and will be dismissed with prejudice.  This Settlement Agreement and Release does not affect the claims of any other Plaintiff or Intervenor in the Adcock matter.

On August 9, 2006, Riley Middleton intervened in the Adcock case. The intervenor (i) alleges negligence and (ii) seeks damages totaling $233,386 as well as exemplary damages.

On April 10, 2006, the following lawsuit was filed in the 31st Judicial District Court of Roberts County, Texas, Cause No. 1920, Joseph Craig Hutchison and Judy Hutchison v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc. (“Hutchinson”). The plaintiffs claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The plaintiffs (i) allege negligence and trespass and (ii) seek damages of $621,058, including, but not limited to, damages to their land and certain remedial expenses. In addition, the plaintiffs seek exemplary damages.

On May 1, 2006, the following lawsuit was filed in the 31st Judicial District Court of Roberts County, Texas: Cause No. 1923, Chisum Family Partnership, Ltd. v. Cano, W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd. and WO Energy, Inc. (“Chisum”). The plaintiff claims that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The plaintiff (i) alleges negligence and trespass and (ii) seeks damages of $53,738.82, including, but not limited to, damages to their land and certain remedial expenses. In addition, the plaintiffs seek exemplary damages.

On August 9, 2006, the following lawsuit was filed in the 233rd Judicial District Court of Gray County, Texas, Cause No. 34,423, Yolanda Villarreal, Individually and on behalf of the Estate of Gerardo Villarreal v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd., and WO Energy, Inc. (“Villarreal”). The plaintiffs claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The plaintiffs (i) allege negligence and (ii) seek damages for past and future financial support in the amount of $586,334, in addition to undisclosed damages for wrongful death and survival damages, as well as exemplary damages, for the wrongful death of Gerardo Villarreal who they claim died as a result of the fire. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable under vicarious liability theories. On

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August 22, 2006, relatives of Roberto Chavira intervened in the case alleging similar claims and seeking damages for lost economic support and lost household services in the amount of $894,078, in addition to undisclosed damages for wrongful death and survival damages, as well as exemplary damages regarding the death of Roberto Chavira.

On March 14, 2007, the following lawsuit was filed in 100th Judicial District Court in Carson County, Texas; Cause No. 9994, Southwestern Public Service Company d/b/a Xcel Energy v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc. (“SPS”). The plaintiff claims that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The plaintiff (i) alleges negligence and breach of contract and (ii) seeks $1,876,000 in damages for loss and damage to transmission and distribution equipment, utility poles, lines and other equipment. In addition, the plaintiff seeks reimbursement of its attorney’s fees.

On May 2, 2007, the following lawsuit was filed in the 84^th Judicial District Court of Hutchinson County, Texas, Cause No. 37,619, Gary and Genia Burgess, et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Burgess”). Eleven plaintiffs claim that electrical wiring and equipment relating to oil and gas operations of the Company or certain of its subsidiaries started a wildfire that began on March 12, 2006 in Carson County, Texas. Five of the plaintiffs are former plaintiffs in the Adcock matter. The plaintiffs (i) allege negligence, res ipsa loquitor, nuisance, and trespass and (ii) seek damages, including, but not limited to, damages to their land, buildings and livestock and certain remedial expenses totaling approximately $1,997,217.86. In addition, the plaintiffs seek (i) reimbursement for their attorney’s fees and (ii) exemplary damages. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or as a partnership or de facto partnership. By Settlement Agreement and Release signed by all parties on November 5, 2008, the claims of all plaintiffs in this suit were resolved and will be dismissed with prejudice.

On May 15, 2007, William L. Arrington, William M. Arrington and Mark and Le’Ann Mitchell intervened in the SPS case. The intervenors (i) allege negligence, res ipsa loquitor, nuisance, and trespass and (ii) seek damages, including, but not limited to, damages to their land, buildings and livestock and certain remedial expenses totaling approximately $118,320. In addition, the intervenors seek (i) reimbursement for their attorney’s fees and (ii) exemplary damages. The intervenors also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or a general partnership or de facto partnership. By Settlement Agreement and Release signed by all parties on November 5, 2008, the claims of these Intervenors were resolved and will be dismissed with prejudice.  This Settlement Agreement and Release does not affect the claims of any other Plaintiff or Intervenor in this matter.

On September 25, 2007, the Texas Judicial Panel on Multidistrict Litigation granted Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W. O. Operating Company, Ltd, and WO Energy, Inc.’s Motion to Transfer Related Cases to Pretrial Court pursuant to Texas Rule of Judicial Administration 13. The panel transferred all pending cases (Adcock, Chisum, Hutchison, Villarreal, SPS, and Burgess, identified above, and Valenzuela, Abraham Equine, Pfeffer, and Ayers, identified below) that assert claims against the Company and its subsidiaries related to wildfires beginning on March 12, 2006 to a single pretrial court for consideration of pretrial matters. The panel transferred all then-pending cases to the Honorable Paul Davis, retired judge of the 200th District Court of Travis County, Texas, as Cause No. D-1-GN-07-003353.

On October 3, 2007, Firstbank Southwest, as Trustee for the John and Eddalee Haggard Trust (the “Trust”) filed a Petition in intervention as part of the Hutchison case. The Trust claims that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The Trust (i) alleges negligence and trespass and (ii) seeks damages of $46,362.50, including, but not limited to, damages to land and certain remedial expenses. In addition, the Trust seeks exemplary damages.

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On December 18, 2007, the following lawsuit was filed in the 348^th Judicial District Court of Tarrant County, Texas, Cause No. 348-227907-07, Norma Valenzuela, et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Valenzuela”). Six plaintiffs, including the two plaintiffs and intervenor from the nonsuited Martinez case, claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County, Texas. The plaintiffs (i) allege negligence and (ii) seek actual damages in the minimal amount of $4,413,707 for the wrongful death of four relatives, Manuel Dominguez, Roberto Chavira, Gerardo Villarreal and Medardo Garcia, who they claim died as a result of the fire. In addition, plaintiffs seek (i) reimbursement for their attorney’s fees and (ii) exemplary damages. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or as a partnership or de facto partnership. Cano and its subsidiaries filed a Motion to Dismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Along transferring the case to the Multidistrict Litigation Case in the 200^th Judicial District Court of Travis County, Texas. On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in the Alternative, to Transfer Venue and took the motion under advisement.

On January 10, 2008, Philip L. Fletcher intervened in the consolidated case in the 200th District Court of Travis County, Texas as part of the SPS case. The intervenor (i) alleges negligence, trespass and nuisance and (ii) seeks damages of $120,408, including, but not limited to, damages to his livestock, attorney’s fees and exemplary damages. The intervenor also claims that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or as a partnership or de facto partnership.

On January 15, 2008, the Jones and McMordie Ranch Partnership intervened in the consolidated case in the 200th District Court of Travis County, Texas as part of the SPS case. The intervenor (i) alleges negligence, trespass and nuisance and (ii) seeks damages of $86,250.71, including, but not limited to, damages to his livestock, attorney’s fees and exemplary damages. The intervenor also claims that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or as a partnership or de facto partnership.

On February 11, 2008, the following lawsuit was filed in the 48^th Judicial District Court of Tarrant County, Texas: Cause No. 048-228763-08, Abraham Equine, Inc. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Abraham Equine”). The plaintiff claims that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County. The plaintiff (i) alleges negligence, trespass and nuisance and (ii) seeks damages of $1,608,000, including, but not limited to, damages to its land, livestock and lost profits. In addition, the plaintiff seeks (i) reimbursement for its attorney’s fees and (ii) exemplary damages. The plaintiff also claims that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or a general partnership or de facto partnership. Cano and its subsidiaries filed a Motion to Dismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Along transferring the case to the Multidistrict Litigation Case in the 200^th Judicial District Court of Travis County, Texas. On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in the Alternative, to Transfer Venue and took the motion under advisement.  This suit (along with the claims of Abraham Brothers, LP, Edward C. Abraham, Salem A. and Ruth Ann Abraham and Jason M. Abraham, discussed above) was resolved through a Settlement and Release Agreement effective October 12, 2008 and will be dismissed with prejudice.

On March 10, 2008, the following lawsuit was filed in the 352^nd Judicial District Court of Tarrant County, Texas, Cause No. 352-229256-08, Gary Pfeffer v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Pfeffer”). The plaintiff claims that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County. The plaintiff (i) alleges negligence, trespass and nuisance, (ii) seeks undisclosed damages for the wrongful death of his father, Bill W. Pfeffer, who he claims died as a result of the fire and (iii) seeks actual damages of $1,023,572.37 for damages to his parents’ home and property. In addition, the plaintiff seeks exemplary damages. The plaintiff also claims that Cano and its subsidiaries are jointly and severally liable as a general partnership or de facto partnership. Cano and its subsidiaries filed a Motion to Dismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Along transferring the case to the Multidistrict Litigation Case in the 200^th Judicial District Court of Travis County, Texas. On May 2, 2008, the

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Court heard Cano’s Motion to Dismiss or, in the Alternative, to Transfer Venue and took the motion under advisement.

On March 11, 2008, the following lawsuit was filed in the 141^st Judicial District Court of Tarrant County, Texas, Cause No. 141-229281-08, Pamela Ayers, et al. v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Ayers”). The plaintiffs claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County. The plaintiffs (i) allege negligence and (ii) seek undisclosed damages for the wrongful death of their mother, Kathy Ryan, who they claim died as a result of the fire. In addition, the plaintiffs seek exemplary damages. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or general partnership or de facto partnership. Cano and its subsidiaries filed a Motion to Dismiss or, in the Alternative, to Transfer Venue and a Notice of Tag Along transferring the case to the Multidistrict Litigation Case in the 200^th Judicial District Court of Travis County, Texas. On May 2, 2008, the Court heard Cano’s Motion to Dismiss or, in the Alternative, to Transfer Venue and took the motion under advisement.

On March 12, 2008, the following lawsuit was filed in the 17^th Judicial District Court of Tarrant County, Texas, Cause No. 017-229316-08, The Travelers Lloyds Insurance Company and Travelers Lloyds of Texas Insurance Company v. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating, Ltd. and WO Energy, Inc. (“Travelers”). The plaintiffs claim that the electrical wiring and equipment of Cano or certain of its subsidiaries relating to oil and gas operations started a wildfire that began on March 12, 2006 in Carson County. The plaintiffs (i) allege negligence, res ipsa loquitor, and trespass and (ii) claim they are subrogated to the rights of their insureds for damages to their buildings and building contents totaling $447,764.60. The plaintiffs also claim that Cano and its subsidiaries are jointly and severally liable as a single business enterprise and/or general partnership or de facto partnership.

On August 15, 2008, the trial court denied motions for summary judgment filed by Cano in the Adcock, Chisum, Hutchinson, Villarreal, SPS, Burgess, and Valenzuela cases. The SPS case is set for jury trial on February 16, 2009. None of the other above-mentioned cases are currently set for trial; however, the Company anticipates that the trial court will set these matters for jury trials.

Due to the inherent risk of litigation, the ultimate outcome of these cases and any jury trial is uncertain and unpredictable (see “Part II, Item 1A – Risk Factors – Risks Related to Our Business – We are subject to several lawsuits relating to a fire that occurred on March 12, 2006 in Carson County, Texas which may have an adverse impact on us”).  At this time, Cano management believes that the lawsuits are without merit and will continue to vigorously defend itself and its subsidiaries, while seeking solutions to resolve these lawsuits in a cost-effective manner.

Insurance Settlements Related to the Fire Litigation

On June 20, 2006, the following lawsuit was filed in the United States District Court for the Northern District of Texas, Fort Worth Division, C.A. No. 4-06cv-434-A, Mid-Continent Casualty Company, Plaintiff, vs. Cano Petroleum, Inc., W.O. Energy of Nevada, Inc., W.O. Operating Company, Ltd. and W.O. Energy, Inc. seeking a declaration that the plaintiff is not responsible for pre-tender defense costs and that the plaintiff has the sole and exclusive right to select defense counsel and to defend, investigate, negotiate and settle the litigation described above. On September 18, 2006, the First Amended Complaint for Declaratory Judgment was filed with regard to the cases described above. Cano and its subsidiaries were served with the lawsuit between September 26-28, 2006.

On February 9, 2007, Cano and its subsidiaries entered into a Settlement Agreement and Release with the plaintiff pursuant to which in exchange for mutual releases, in addition to the approximately $923,000 that we have been reimbursed by plaintiff, the plaintiff agreed to pay to Cano within 20 business days of February 9, 2007 the amount of $6,699,827 comprised of the following: (a) the $1,000,000 policy limits of the primary policy; (b) the $5,000,000 policy limits of the excess policy; (c) $500,000 for future defense costs; (d) $144,000

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as partial payment for certain unpaid invoices for litigation related expenses; (e) all approved reasonable and necessary litigation related expenses through December 21, 2006 that are not part of the above-referenced $144,000; and (f) certain specified attorneys fees. During February 2007, we received the $6,699,827 payment from Mid-Con. Of this $6,699,827 amount, the payments for policy limits amounting to $6,000,000, in accordance with the senior credit agreement (Note 4), were placed in a controlled bank account and the use of the proceeds was specified to pay attorneys’ fees, settlement amounts and other litigation expenses incurred to defend and/or settle the fire litigation, and for general corporate purposes. These proceeds have been fully expended.

On March 11, 2008, one of Cano’s subsidiaries entered into a tolling agreement with Kel-Tex Electric, Inc. (“Kel-Tex”), an electrical contractor that was identified as a potentially responsible third party in connection with the claims related to the pending wildfire litigation against Cano and its subsidiaries.  In accordance with the terms of a Settlement Agreement and Release effective October 11, 2008, Kel-Tex  paid Cano for its full insurance policy limits totaling $6.0 million in exchange for a full release of any existing or future claims related to wildfires that began on March 12, 2006 in Carson County, Texas, which was fully received on October 31, 2008.  This $6.0 million has been fully expended to cover portions of the settlements described above and is not included, as of September 30, 2008, in the $6.0 million liability under deferred litigation credit as presented on our consolidated balance sheet.  Based on our knowledge and judgment of the facts as of September 30, 2008, we believe the deferred litigation credit balance is adequate.

Securities Litigation against Outside Directors

On October 2, 2008, the following lawsuit (08 CV 8462) was filed in the United States District Court for the Southern District of New York against David W. Wehlmann; Gerald W. Haddock; Randall Boyd; Donald W. Niemiec; Robert L. Gaudin; William O. Powell, III, and the underwriters alleging violations of the federal securities laws.  The plaintiff seeks to certify the lawsuit as a class action.  The lawsuit alleges that the prospectus for the June 26, 2008 public offering of Cano common stock contained statements regarding Cano’s proved reserve amounts and standards that were materially false and overstated Cano’s proved reserves.  Messrs. Wehlmann, Haddock, Boyd, Niemiec, Gaudin and Powell were Cano outside directors on June 26, 2008.  The lawsuit seeks an unspecified amount of damages for the class if the lawsuit is certified as a class action.  Due to the inherent risk of litigation, the outcome of this lawsuit is uncertain and unpredictable; however, at this time, managment believes the lawsuit is without merit and is vigorously supporting its outside directors in the defense of the claims against them.

Other

Occasionally, we are involved in other various lawsuits and certain governmental proceedings arising in the ordinary course of business. Our management does not believe that the ultimate resolution of any current matters that are not set forth above, will have a material effect on our financial position or results of operations. Management’s position is supported, in part, by the existence of insurance coverage, indemnification and escrow accounts. None of our directors, officers or affiliates, owners of record or beneficial owners of more than five percent of any class of our voting securities, or security holder is involved in a proceeding adverse to us or our subsidiaries or has a material interest adverse to us or our subsidiaries.

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Item 2. Management’s Discussion and Analysis on Financial Condition and Results of Operations

Forward-Looking Statements