UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended: December 31, 2010

OR

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

For the transition period from                                to                               

Commission File Number: 001-32496

Cano Petroleum, Inc.

(Exact name of registrant as specified in its charter)

(214) 687-0030

(Registrant’s telephone number, including area code)

N/A

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

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 preceding 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o 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.

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

The number of shares outstanding of the registrant’s common stock, par value $.0001 per share, as of February 14, 2011 was 45,403,749 shares.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

CANO PETROLEUM, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

In Thousands, Except Shares and Per Share Amounts

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 STOCKHODLERS’ EQUITY

JULY 1, 2010 THROUGH DECEMBER 31, 2010

(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 CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND USE OF ESTIMATES

Consolidation and Use of Estimates

These interim consolidated financial statements 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 prices for commodity derivatives, interest rates, estimates of reserves, drilling risks, geological risks, transportation restrictions, the timing of events, 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 Annual Report on Form 10-K for the year ended June 30, 2010.

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 Petroleum, Inc. and its wholly-owned subsidiaries (collectively, “Cano”). 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. The computation of stock-based compensation expense requires assumptions such as volatility, expected life and the risk-free interest rate. The computation of mark-to-market valuations of our commodity derivatives include the observability of quoted market prices and an assessment of potential non-performance of counterparties. It is possible these estimates could be revised in the near term, and these revisions could be material.

Significant assumptions are required in the valuation of proved crude oil and natural gas reserves, which may affect the amounts at which crude oil and natural gas properties are recorded. Our estimates of proved reserves materially impact depletion expense. If proved reserves decline, then the rate at which we record depletion expense increases. A decline in estimated proved reserves could result from lower prices, adverse operating results, mechanical problems at our wells and catastrophic events such as fires, hurricanes and floods. Lower prices can make it uneconomical to drill new wells or produce from existing wells with high operating costs. In addition, a decline in proved reserves may impact our assessment of our oil and natural gas properties for impairment. Our proved reserves estimates are based upon many assumptions, all of which could deviate materially from actual results. As such, reserve estimates may vary materially from the ultimate quantities of crude oil and natural gas actually produced.  Based on our June 30, 2010 reserve report, seventy-nine percent of our proved reserves are classified as proved undeveloped reserves. Capital expenditures amounting to $310.5 million are forecasted in our reserve report.  As we have done during each year of our existence, to develop these reserves we will require access to the capital markets and/or consider divestitures of oil and gas properties in each of the next five years, as our projected capital expenditures are greater than projected cash flow from operations through December 2015.

New Accounting Pronouncements

Accounting standards-setting organizations frequently issue new or revised accounting rules. We regularly review all new pronouncements to determine their impact, if any, on our financial statements. No pronouncements materially affecting our financial statements have been issued since the filing of our Form 10-K for the year ended June 30, 2010.

2. LIQUIDITY / GOING CONCERN

At December 31, 2010, we had cash and cash equivalents of $0.2 million. We had negative working capital of $100.5 million, which includes current liabilities of $66.5 million of long-term debt and $27.5 million of Series D convertible preferred stock. For the six-month period ended December 31, 2010, we had cash flow provided by operations of $1.6 million.

On July 20, 2010, we terminated our announced merger with Resaca Exploitation, Inc. (“Resaca”) that had been initiated pursuant to an Agreement and Plan of Merger dated September 29, 2009.  On July 26, 2010 we announced the engagement of Canaccord Genuity and Global Hunter Securities to assist our Board in a review of strategic alternatives, with a goal of maximizing value for our shareholders.  The strategic alternatives we are considering include the sale of the Company, the sale of some or all of our existing oil and gas properties and assets, potential business combinations and/or recapitalizing the Company. We continue to focus on cost reduction efforts to improve both our profitability and cash flow from operations.

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We currently have limited access to capital. On August 6, 2010, we finalized Consent and Forbearance Agreements with the lenders under our credit agreements that waived potential covenant compliance issues for the periods ending June 30, 2010 and September 30, 2010, set certain deadlines for the execution of our strategic alternatives process and allowed us to sell certain natural gas commodity derivative contracts for cash proceeds of $0.8 million, which was intended to provide Cano sufficient liquidity to complete its strategic alternatives process. The Consent and Forbearance Agreements were terminated as our lenders delivered Reservation of Rights Letters dated September 24, 2010 and January 5, 2011, as discussed in Note 3.  We continue to work with our lenders and advisors as we consider strategic alternatives.  As of February 14, 2011, our lenders have taken no actions associated with the termination of the Consent and Forbearance Agreements.  We currently have no available borrowing capacity under our senior and subordinated credit agreements.

The accompanying consolidated financial statements have been prepared on a going concern basis which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. There is no assurance that the carrying amounts of assets will be realized or that liabilities will be settled for the amounts recorded. The ability of the Company to continue as a going concern will be dependent upon the outcome of our strategic alternatives review.

3. DEBT

At December 31, 2010 and June 30, 2010, the outstanding amount due under our credit agreements was $66.5 million. The $66.5 million consisted of outstanding borrowings under the amended and restated credit agreement (the “ARCA”) and the subordinated credit agreement (the “SCA”) of $51.5 million and $15.0 million, respectively. At December 31, 2010, the average interest rates charged by the lenders under the ARCA and SCA were 3.02% and 6.31%, respectively.

On August 5, 2010, we executed a Consent and Forbearance Agreement (the “Senior Forbearance Agreement”) with Union Bank, N.A. (“UBNA”) and Natixis relating to existing and potential defaults under the ARCA dated December 17, 2008 among Cano, UBNA and Natixis and a Consent and Forbearance Agreement (together with the Senior Forbearance Agreement, the “Forbearance Agreements”) with UnionBanCal Equities, Inc. (“UBE”), relating to existing defaults under the SCA dated December 17, 2008 between Cano and UBE (as amended, the SCA and together with the ARCA, the “Credit Agreements”).

On September 24, 2010, our lenders delivered Reservation of Rights Letters (“Letters”), subsequently updated on January 5, 2011, specifying that we failed to timely comply with the material terms of the Forbearance Agreements and therefore terminated the Forbearance Agreements.  As of February 14, 2011, the lenders have taken no action with the delivery of these Letters.  We have recorded all additional interest and fees due under the terms of the Credit Agreements of $2.0 million in accrued liabilities on our consolidated balance sheet and in interest expense on consolidated statement of operations as of December 31, 2010.  We have also recorded additional interest expense associated with the accelerated amortization of deferred financing costs of $0.6 million applicable to the Credit Agreements, and accounting and legal expense incurred by our lenders of $0.4 million.

4. PREFERRED STOCK

On August 5, 2010, we entered into Forbearance Agreements with the lenders under our Credit Agreements that prohibited us from making any indirect or direct cash payment, cash dividend or cash distribution in respect of our shares of Preferred Stock. As discussed under Note 3, the Forbearance Agreements were terminated.  As of December 31, 2010, we have not remitted cash dividend payments for the Preferred Stock of $0.4 million for the three-month periods ended September 30, 2010 and December 31, 2010. As of December 31, 2010, the unpaid cash dividend of $0.4 million is included in accrued liabilities reported in our consolidated balance sheets. Due to the non-payment of the cash dividends, along with the fact that the Preferred Stock is redeemable for cash as of September 6, 2011, our Preferred Stock has been reclassified from Temporary Equity to a current liability of $27.5 million on our consolidated balance sheet, which is the liquidation preference of $28.7 million less unamortized issuance costs of $1.2 million, which is presented as a discount on the consolidated balance sheet as of December 31, 2010.  Issuance costs of $0.4 million were amortized in preferred stock dividend during the three-month period ended December 31, 2010.

S. Jeffrey Johnson, our former Chief Executive Officer and former Chairman of our board of directors, owns approximately 3.5% of our outstanding Preferred Stock. For the three-month periods ended December 31, 2010 and 2009, we paid preferred dividend payments to Mr. Johnson of approximately $0 and $20,000, respectively.  For the six-month periods ended December 31, 2010 and 2009, we paid preferred dividend payments to Mr. Johnson of approximately $0 and $39,000, respectively.

If any Preferred Stock remains outstanding on September 6, 2011, we are required to redeem the Preferred Stock for a redemption amount in cash equal to the stated value of the Preferred Stock, plus accrued cash and paid-in-kind dividends.  If we do not redeem the Preferred Stock (including accrued cash and paid-in-kind dividends) for cash on September 6, 2011, the redemption value of the Preferred Stock will accrue interest at 1.5% per month until Cano has made settlements with the preferred stockholders.

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The subordination provisions of the Certificate of Designations of our Preferred Stock may prohibit us from redeeming any of the Preferred Stock on September 6, 2011.

5. DERIVATIVES

Our derivatives consist of commodity derivatives and an interest rate swap arrangement, which are discussed in greater detail below.

Commodity Derivatives

Pursuant to the ARCA and SCA discussed in Note 3, we are required to maintain our existing commodity derivative contracts.  We entered into commodity derivative contracts to partially mitigate the risk associated with extreme fluctuations of prices for our crude oil and natural gas sales.  We have no obligation to enter into commodity derivative contracts in the future. Should we choose to enter into commodity derivative contracts to mitigate future price risk, we cannot enter into contracts for greater than 85% of our crude oil and natural gas production volumes attributable to proved producing reserves for a given month. As of December 31, 2010, we maintained the following “collar” commodity derivative contracts with UBNA as our counterparty, which is one of the senior lenders under the ARCA:

(a)        This column is computed by dividing the “Mcf per Day” by 6 and adding it to “Barrels per Day.”

(b)        On February 8, 2011, these crude oil derivative contracts were terminated at no cost to either party.

On September 11, 2009, we entered into two fixed price commodity swap contracts with Natixis as our counterparty, which is one of our senior lenders under the ARCA. The fixed price swaps are based on West Texas Intermediate NYMEX prices and are summarized in the table below.

Interest Rate Swap Agreement

On January 12, 2009, we entered into a three-year LIBOR interest rate basis swap contract with Natixis Financial Products, Inc. (“Natixis FPI”) for $20.0 million in notional exposure. We entered into the interest rate swap agreement to partially mitigate the risk associated with rising interest rates.  Under the terms of the transaction, we will pay Natixis FPI, in three-month intervals, a fixed rate of 1.73% and Natixis FPI will pay Cano the prevailing three-month LIBOR rate.

Financial Statement Impact

During the three-month and six-month periods ended December 31, 2010 and 2009, respectively, the gain (loss) on derivatives reported in our consolidated statements of operations is summarized as follows:

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On August 10, 2010, we sold certain natural gas commodity derivative contracts realizing net proceeds of $0.8 million pursuant to the Forbearance Agreements. The cash settlements received/accrued by us under commodity derivatives 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 periods and realized gains from the sale of uncovered “floor price” contracts as previously discussed. The cash settlements paid/accrued by us under commodity derivatives were cumulative monthly payments due to our counterparty since the NYMEX crude oil and natural gas prices were higher than the ceiling prices set for the respective time periods. The cash settlements paid/accrued by us under the interest rate swap were quarterly payments to our counterparty since the actual three-month LIBOR interest rate was lower than the fixed 1.73% rate we pay to the counterparty. 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 as changes to current assets and current liabilities. At December 31, 2010 and June 30, 2010, we had recorded a receivable from our counterparty included in accounts receivable on our consolidated balance sheet of $0.1 million and $0.3 million, respectively.

The unrealized gain (loss) on commodity derivatives represents estimated future settlements under our commodity derivatives and is based on mark-to-market valuation based on assumptions of forward prices, volatility and the time value of money as discussed below. We compared our internally derived valuation to our counterparties’ independently derived valuation to further validate our mark-to-market valuation.

The unrealized gain (loss) on interest rate swap represents estimated future settlements under our interest rate swap agreement and is based on a mark-to-market valuation based on assumptions of interest rates, volatility and the time value of money as discussed below.

Fair Value Measurements

Our 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. A fair value hierarchy has been established 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.

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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 Level 3 input pertained to the subjective valuation for the effect of our own credit risk, which was significant to the fair value of the crude oil swap derivative contracts. The fair value of our commodity derivative contracts and interest rate swap are measured using Level 2 inputs based on the hierarchies previously discussed.

The estimated fair value of derivatives included in the consolidated balance sheet at December 31, 2010 is summarized below.

The following table shows the reconciliation of changes in the fair value of the net derivative assets classified as Level 2 and 3, respectively, in the fair value hierarchy for the three months ended December 31, 2010 (in thousands).

The change from net derivative assets of $1.2 million at June 30, 2010 to net derivative liabilities of $6.9 million at December 31, 2010 is attributable to the increases in crude oil and natural gas futures prices and settlements that occurred during the six-month period. These amounts are based on our mark-to-market valuation of these derivatives at December 31, 2010 and may not be indicative of actual future cash settlements.

The following table summarizes the fair value of our derivative contracts as of the dates indicated:

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6. DISCONTINUED OPERATIONS

On January 27, 2010, we completed the sale of our interests in certain oil and gas properties located in the Texas Panhandle (“Certain Panhandle Properties”) for net proceeds of $6.3 million, subject to customary post-closing adjustments. The sale had an effective date of January 1, 2010. The operating results of the Certain Panhandle Properties for the three-month and six-month periods ended December 31, 2009 have been reclassified as discontinued operations in the consolidated statements of operations as detailed in the table below (in thousands).

Interest expense, net of interest income, was allocated to discontinued operations based on the percent of operating revenues applicable to discontinued operations to the total operating revenues.

7. STOCK OPTIONS

During the six-month period ended December 31, 2010, we did not grant additional stock options.  A summary of outstanding options as of December 31, 2010 is as follows:

Based on our $0.38 stock price at December 31, 2010, there was no intrinsic value of both the options outstanding and exercisable.

Total options exercisable at December 31, 2010 amounted to 980,780 shares and had a weighted average exercise price of $4.23. 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 the three- and six-month periods ended December 31, 2010, our recordings for stock-based compensation expense were insignificant. For the three- and six-month periods ended December 31, 2009, we recorded a charge to stock-based compensation expense of $0.1 million and $0.2 million, respectively.  As of December 31, 2010, we had fully expensed the total compensation cost related to the outstanding option awards.

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8. DEFERRED COMPENSATION

As of December 31, 2010, we had non-vested share awards totaling 73,334 shares to key employees pursuant to our 2005 Long-Term Incentive Plan, as summarized below:

The share awards will vest to the employees by July 2, 2011. The fair values of the awards are based on our actual stock price on the date of grant multiplied by the number of shares granted.  As of December 31, 2010, the grant date fair value of non-vested shares amounted to $0.5 million.  For the three-month period ended December 31, 2010, we recorded a credit to stock-based compensation expense of $0.1 million, primarily due to award forfeitures. For the six-month period ended December 31, 2010, we had insignificant stock-based compensation expense.  For the three- and six-month periods ended December 31, 2009, we have expensed $0.2 million and $0.5 million, respectively, to stock-based 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 share awards and employee termination.

9. NET LOSS PER COMMON SHARE

Basic net loss per common share is computed by dividing the net loss attributable to common shareholders by the weighted average number of shares of common stock outstanding. Diluted net 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 and paid-in-kind (“PIK”) dividends on an “as-converted” basis.

Shares of common stock underlying the following items were not included in dilutive weighted average shares outstanding for the three- and six-month periods ended December  31, 2010 and 2009, as their effects would have been anti-dilutive.

10. 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 claimed 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) alleged negligence and gross negligence and (ii) sought 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 sought (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 claimed that Cano and its subsidiaries were 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 100th 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 was appealed and a decision was reached on March 11, 2009, as the Court of Appeals for the Tenth District of Texas in Amarillo affirmed in part and reversed in part the ruling of the 100th Judicial District Court. The Court of Appeals (a) affirmed the trial court’s granting of summary judgment in Cano’s favor for breach of contract/termination of an oil and gas lease and (b) reversed the trial court’s granting of summary judgment in Cano’s favor on plaintiffs’ claims of Cano’s negligence. The Court of Appeals ordered the case remanded to the 100th Judicial District Court. On March 30, 2009, the plaintiffs filed a motion for rehearing with the Court of Appeals and requested a rehearing on the affirmance of the trial court’s holding on the plaintiffs’ breach of contract/termination of an oil and gas lease claim. On June 30, 2009, the Court of Appeals ruled to deny the plaintiff’s motion for rehearing. On August 17, 2009, Cano filed an appeal with the Texas Supreme Court to request the reversal of the Court of Appeals ruling regarding our potential negligence. On December 11, 2009, the Texas Supreme Court declined to hear Cano’s appeal.

This lawsuit was resolved through a Settlement and Release Agreement effective October 19, 2010, pursuant to which this lawsuit has been dismissed without prejudice. The dismissal without prejudice will automatically convert to a dismissal with prejudice, thus foreclosing the plaintiffs’ ability to re-file this suit, once we have fully satisfied the obligations contained in the

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Settlement and Release Agreement.  Based on our knowledge and judgment of the facts as of February 14, 2011, our financial statements dated December 31, 2010 present fairly the effect of the actual and the anticipated future costs to resolve this matter.

Securities Litigation against Outside Directors

On October 2, 2008, a 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 of the June 26, 2008 public offering of Cano common stock (“Secondary Offering”) alleging violations of the federal securities laws. Messrs. Wehlmann, Haddock, Boyd, Niemiec, Gaudin and Powell were Cano outside directors on June 26, 2008. At the defendants’ request, the case was transferred to the United States District Court for the Northern District of Texas.

On July 2, 2009, the plaintiffs filed an amended complaint that added as defendants Cano, Cano’s Chief Executive Officer and Chairman of the Board, Jeff Johnson, Cano’s former Senior Vice President and Chief Financial Officer, Morris B. “Sam” Smith, Cano’s former Senior Vice President and Chief Financial Officer, Ben Daitch, Cano’s current Senior Vice President and Chief Financial Officer, Michael Ricketts and Cano’s former Senior Vice President of Engineering and Operations, Patrick McKinney, and dismissed Gerald W. Haddock, a former director of Cano, as a defendant. The amended complaint alleges that the prospectus for the Secondary Offering contained statements regarding Cano’s proved reserve amounts and standards that were materially false and overstated Cano’s proved reserves. The plaintiff is seeking to certify the lawsuit as a class action lawsuit and is seeking an unspecified amount of damages. On July 27, 2009, the defendants moved to dismiss the lawsuit. On December 3, 2009, the U.S. District Court for the Northern District of Texas granted motions to dismiss all claims brought by the plaintiffs. On December 18, 2009, the plaintiffs filed a notice of appeal with the U.S. Court of Appeals for the Fifth Circuit. On April 5, 2010, Cano filed its appellate brief to support its position.  On April 19, 2010, the plaintiffs filed their response brief. On August 4, 2010, the U.S. Court of Appeals for the Fifth Circuit affirmed the dismissal by the U.S. District Court for the Northern District of Texas of all claims by the plaintiffs.  By affirming the decision of the lower court, the U.S. Court of Appeals for the Fifth Circuit agreed that the plaintiff’s complaint failed to state a claim upon which relief could be granted, and thus found merit in dismissing the lawsuit.

Resaca Claim

Section 7.6 of the Merger Agreement with Resaca Exploitation, Inc. (“Resaca”) provided for the Company and Resaca to share transaction expenses related to the printing, filing and mailing of the registration statement on Form S-4 covering the Resaca shares that would have been issued to Cano stockholders in the merger, the proxy statements relating to the meetings at which the stockholders of Cano and Resaca voted to approve the merger, and the solicitation of stockholder approvals.  On September 2, 2010, we filed an action against Resaca in the Tarrant County District Court seeking a declaratory judgment to clarify the scope and determine the amount of any expenses that are reimbursable under Section 7.6 of the Merger Agreement.  On December 16, 2010, the presiding District Court judge denied Resaca’s request to transfer the venue.  On January 19, 2011, Resaca filed a motion for Partial Summary Judgment to seek reimbursement of certain merger-related expenses totaling $1.1 million, for which Cano’s 50% portion would be $0.5 million.  Based on our knowledge and judgment of the facts as of February 14, 2011, our financial statements dated December 31, 2010 present fairly the effect of the actual and the anticipated future costs to resolve this matter.

Other

Occasionally, we are involved in other various claims and 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.

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

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

The information in this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves provided they identify these statements as forward looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. All statements other than statements of historical fact made in this report are forward looking. In particular, the statements herein regarding industry prospects and future results of operations or financial position are forward-looking statements. Forward-

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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, our ability to successfully execute one of our strategic alternatives, restructure our existing indebtedness, obtain further waivers or forbearance from our lenders, raise new capital, restructure the terms of our Preferred Stock, the volatility in prices for crude oil and natural gas, future commodity prices for derivative hedging contracts, 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.

Statements in this Quarterly Report on Form 10-Q regarding Cano’s strategy, risk factors, capital budget, projected expenditures, liquidity and capital resources, and drilling and development plans reflect Cano’s current plans for the fiscal year ending June 30, 2011 as a stand-alone entity and do not take into account the impact of strategic alternatives being considered by Cano operating on a going concern basis.

You should read the following discussion and analysis in conjunction with the consolidated financial statements of Cano and its 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.

Overview

Introduction

We are an independent oil and natural gas company. Our strategy is to convert our proved undeveloped reserves into proved producing reserves, improve operational efficiencies in our existing properties and acquire accretive proved producing assets.  We intend to manage our assets as both an operator and non-operated participation. We expect to seek joint venture partners to exploit proved undeveloped reserves at some of our existing properties. Our assets are located onshore in the U.S. in Texas, New Mexico and Oklahoma.

Operating Activities Update

For the quarter ended December 31, 2010 (“current quarter”) our production averaged 927 net barrels of oil equivalent per day (BOEPD) as compared to production of 1,071 BOEPD for the quarter ended December 31, 2009 (“prior year quarter”). For the six-month period ended December 31, 2010 (“current six months”) our production averaged 1,016 BOEPD as compared to production of 1,087 BOEPD for the six months ended December 31, 2009 (“prior year six months”). For both the current quarter and the current six-month period, we had production increases from the workover activities, behind-pipe recompletions in the Atoka Formation and return-to-production (“RTP”) program at the Desdemona Properties and improved operational efficiencies at the Davenport Properties. These increases were more than offset by decreased production at the Cato and Panhandle Properties, which is further discussed below.  Production at the Nowata Properties remained relatively unchanged during the comparative periods.

For the current quarter and current six months, we incurred development capital expenditures of $0.5 million and $1.1 million, respectively, (excludes capitalized general and administrative and interest expenses).

For December 2010, our production averaged 972 BOEPD.  The following is a discussion of our field level activity during the six-month period ended December 31, 2010.

Cato Properties.

On May 6, 2010, we received administrative approval from the New Mexico Oil and Gas Conservation Division (“NMOGCD”) to increase injection pressures at the 14 active injection wells.  On August 5, 2010, we received an expansion permit from the NMOGCD to further expand the waterflood operations. As a result, we have increased water injection rates at Phase 1 project at the Cato Properties covering 1,000 acres.

During mid-October 2010, production was adversely affected by a weather-related electrical outage.  Production was shut-in for 30 days, which resulted in lost production of 75 BOEPD during the current quarter. During the outage, we installed larger electric submersible pumps (“ESP’s”) in both existing and RTP wells, and implemented necessary facility upgrades to optimize our infrastructure.  Our current configuration will be adequate for the Phase 1 waterflood project. As of December 31, 2010, we have increased our injection rate to 13,500 barrels of water injected per day (“BWIPD”), which is 1,500 BWIPD higher than the injection rate of 12,000 BWIPD at September 30, 2010.  We have seen increased fluid production rates and corresponding increasing crude oil rates as a direct result of this work.  During December 2010, our production averaged 214 BOEPD.  From January 2011 through June

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2011, we intend to develop PDNP reserves in the Queen Sands formation and expect continued production improvements from the waterflood operations.

Davenport Properties.  Net production for the current quarter and current six months was 81 BOEPD and 83 BOEPD, respectively. Net production for the prior year quarter and prior year six months was 73 BOEPD for each period.  We are currently assessing the economic feasibility of an RTP project to activate non-producing wells.  During December 2010, our production averaged 84 BOEPD.

Desdemona Properties.  During the current six months, we maintained our focus on optimizing field efficiency, activating RTP wells and completed upgrades to our gas plant to sell all natural gas and natural gas liquids produced from the Duke Sand formation and new production from behind-pipe completions in the Atoka formation. Through December 31, 2010, we had completed two RTP wells in the Duke Sands formation at a cost of $25,000 per well and recompleted two wells into the Atoka formation that cost approximately $25,000 per well.  Each Atoka well recompletion had initial production 125 mcfpd (21 BOEPD) and stabilized at 75 mcfpd (13 BOEPD).  Sales of the production from the Atoka wells will begin once we install additional compression capacity. During December 2010, our production averaged 71 BOEPD.  From January 2011 through June 2011, we expect production improvements from the Duke Sands RTP project, as well as recompletions in the Atoka formation.

Nowata Properties.  We are currently assessing the viability to increase production by expanding the gas gathering system to connect additional wells to increase casinghead gas sales and optimizing current infrastructure.  During December 2010, our production averaged 217 BOEPD at the Nowata Properties, and has remained relatively flat since its acquisition in September 2004.

Panhandle Properties.  During the quarter ended September 30, 2010, we reduced the rate of waterflood injection at the Cockrell Ranch unit to optimize crude oil production and gain improved operational efficiencies.  Although this resulted in lost production of 30 BOEPD, operating margins have improved.  Our natural gas production decreases for both the quarter and six-month period resulted from gas plant outages by DCP Midstream, L.P., which adversely impacted our production by 60 BOEPD.  During December 2010, our production averaged 386 BOEPD.

Liquidity and Capital Resources

At December 31, 2010, we had cash and cash equivalents of $0.2 million. We had negative working capital of $100.5 million, which includes current liabilities of $66.5 million of long-term debt and $27.5 million of Series D convertible preferred stock. For the current six months, we had cash flow provided by operations of $1.6 million, which is an improvement of $2.5 million as compared to the prior year six months.

On July 20, 2010, we terminated our announced merger with Resaca Exploitation, Inc. (“Resaca”) that had been initiated pursuant to an Agreement and Plan of Merger dated September 29, 2009.  On July 26, 2010 we announced the engagement of Canaccord Genuity and Global Hunter Securities to assist our Board in a review of strategic alternatives, with a goal of maximizing value for our shareholders.  The strategic alternatives we are considering include the sale of the Company, the sale of some or all of our existing oil and gas properties and assets, potential business combinations and/or recapitalizing the Company. We continue to focus on cost reduction efforts to improve both our profitability and cash flow from operations.  Our cost reduction efforts have resulted in lower operating expenses for the current quarter and current six months of $7.1 million and $9.0 million, respectively.  Our primary focus is reducing lease operating expenses and general and administrative expenses.  We have been able to reduce operating expenses, while maintaining constant operating revenues.  This is further discussed under “Results of Operations — Operating Expenses.”

We currently have limited access to capital. On August 6, 2010, we finalized Consent and Forbearance Agreements with the lenders under our credit agreements that waived potential covenant compliance issues for the periods ending June 30, 2010 and September 30, 2010, set certain deadlines for the execution of our strategic alternatives process and allowed us to sell certain natural gas commodity derivative contracts for cash proceeds of $0.8 million, which was intended to provide Cano sufficient liquidity to complete its strategic alternatives process. The Consent and Forbearance Agreements were terminated as our lenders delivered Reservation of Rights Letters dated September 24, 2010 and January 5, 2011, as discussed in Note 3 to our Consolidated Financial Statements.  We continue to work with our lenders and advisors as we consider strategic alternatives.  As of February 14, 2011, our lenders have taken no actions associated with the termination of the Consent and Forbearance Agreements.  We currently have no available borrowing capacity under our senior and subordinated credit agreements.

The accompanying consolidated financial statements have been prepared on a going concern basis which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. There is no assurance that the carrying amounts of assets will be realized or that liabilities will be settled for the amounts recorded. The ability of the Company to continue as a going concern will be dependent upon the outcome of our strategic alternatives review.

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Under both the ARCA and SCA, we were not in compliance with the covenants relating to our current ratio, leverage ratio and interest coverage ratio for the quarter ended December 31, 2010.  We have not made any borrowings since July 2010.  We continue to make our interest payments timely to the lenders.

Results of Operations

Overall

For the current quarter, we had a loss applicable to common stock of $4.5 million, which was an improvement of $4.3 million as compared to the prior year quarter of a $8.9 million loss applicable to common stock. The $4.3 million earnings improvement primarily related to lower operating expenses of $7.1 million and decreased loss on derivatives of $1.2 million, partially offset by increased interest expense of $0.9 million and increased preferred stock dividend of $0.5 million.

For the current six months, we had a loss applicable to common stock of $9.6 million, which was an improvement of $3.3 million as compared to the $12.9 million loss applicable to common stock incurred for the prior year six months. Items contributing to the $3.3 million earnings improvement were lower operating expenses of $9.0 million and higher operating revenues of $1.3 million. Partially offsetting these positive items were increased interest expense of $3.5 million, increased loss on derivatives of $1.0 million and increased preferred stock dividend of $0.5 million.

These items will be further addressed in the following discussion.

Operating Revenues

The table below summarizes our operating revenues for the three- and six-month periods ended December 31, 2010 and 2009.