Forward-Looking Statements

The information in this 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-looking statements reflect management's current expectations and are inherently uncertain. Our actual results may differ significantly from management's expectations as a result of many factors, including, but not limited to the volatility in prices for crude oil and natural gas, 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.

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

Operating Strategy

We are an independent oil and natural gas company that utilizes enhanced oil recovery ("EOR") techniques to increase production and reserves at our existing properties and properties acquired in the future. Our assets are located onshore U.S. in Texas, New Mexico and Oklahoma. Our focus on domestic, mature oil fields eliminates exploration risk and the uncertainty associated with international development. We primarily use waterflooding and EOR, such as alkaline/ surfactant/ polymer ("ASP") technology to develop our properties.

We believe our current portfolio of oil and natural gas properties provides ample opportunities to apply our operational strategy. As of June 30, 2008, pro forma for the sale of Pantwist, LLC as discussed in Note 2, we had proved reserves of 50,749 MBOE, of which 8,717 MBOE were proved producing, 2,491 MBOE were proved non-producing, and 39,541 MBOE were proved undeveloped. Crude oil reserves accounted for 74% of our pro forma total proved reserves at June 30, 2008.

During the fiscal year ended June 30, 2008 and continuing into our current fiscal year ending June 30, 2009 ("2009 Fiscal Year"), our primary emphasis is to develop our existing oil and natural gas properties through activities such as waterflooding and EOR technology. These development activities are more clearly defined in the next section titled "Drilling Capital Development Update."

Drilling Capital Development Update

For the 2009 Fiscal Year, we have revised our drilling capital development budget from $97.5 million to $35.5 million due to the recent deterioration in the credit and equity markets, coupled with significantly lower crude oil and natural gas prices. The budget revised allocates capital as follows:

†          $16.5 million at the Cato Properties

†          $12.4 million at the Panhandle Properties

†          $2.2 million at the Nowata Properties

†          $4.0 million at the Desdemona Properties

†          $0.4 million at other projects

Our capital development program includes the drilling of 21 new wells. The financing of our capital expenditures is discussed below under "Liquidity and Capital Resources." The status of our capital development activity during the 2008 Fiscal Year and planned activity during the 2009 Fiscal Year is summarized as follows:

Panhandle Properties. Production at the Cockrell Ranch Unit waterflood has remained at approximately 80-100 net BOEPD for June 2008 through September 2008. During the first quarter, as a result of our previously announced surveillance program, we identified and corrected injectivity issues in 16 of 62 total water injection wells. This work was completed in September 2008. The Cockrell waterflood has been at full injection for only seven months. As we are early in the life of this waterflood, the surveillance measures we have taken are normal. Of note, there are areas of the flood that are responding favorably, with percentage of oil in the total produced fluid in excess of 10%.

The next phase of the waterflood project at the Panhandle field consists of six separate "mini" phases on reduced well spacing that will allow Cano to accelerate field development. Tighter spacing and smaller development patterns should reduce permitting and response times. Our revised capital development plan provides for the development of only one "mini" phase this fiscal year. The Harvey Unit had its waterflood permit application approved by the Texas Railroad Commission on October 20, 2008. We will be ready to initiate injection by calendar year end 2008. Net production at the Panhandle Properties for September 2008 was approximately 610 BOEPD.

Cato Properties. In July 2008, we reinstated our drilling program and have drilled and completed eight additional waterflood infill wells plus one water source well. The revised capital development plan for the 2009 Fiscal Year provides for the drilling of a total of 12 new waterflood pattern wells and to initiate water injection. We received notice on September 9, 2008 of final approval of the waterflood application by the New Mexico Oil and Gas Conservation Commission. We currently have ten water injection wells on-line and anticipate being in positioned to initiate water injection in four additional wells by calendar year end. Net production for September 2008 at the Cato Properties was approximately 340 BOEPD.

Desdemona Properties. We will test a number of Marble Falls and Barnett Shale zones utilizing a second hydraulic fracture stimulation treatment in the first and second quarter. We continue to monitor the pilot waterflood project. We do not expect to see meaningful response from the Duke Sand Waterflood during the 2009 Fiscal Year. Net production for September 2008 at the Desdemona Properties was approximately 60 BOEPD.

Nowata Properties. Our ASP tertiary recovery pilot project, which has been in full operation since December 2007, has injected close to .18 PVI of ASP. Pore volume injection, or PVI, is the amount of void space of a producing formation that has been displaced with water or surfactants, polymers and other additive. We expect an initial response to the ASP pilot by the end of the 2008 calendar year. We plan to continue injecting ASP and will drill four ASP Pilot observation wells in the 2009 Fiscal Year. Net production for September 2008 at the Nowata Properties was approximately 220 BOEPD.

Davenport Properties. Net production for September 2008 was approximately
70 BOEPD.

Corsicana Properties. Net production for September 2008 was approximately 2 BOEPD. In light of current commodity prices and our revised drilling capital budget (as previously discussed), we believe there is uncertainty in the development of Corsicana's proven undeveloped reserves. Therefore, we have recorded a pre-tax $3.5 million impairment of our Corsicana oil and gas properties.

Liquidity and Capital Resources

As discussed in Note 3, we completed the issuance of common stock on July 1, 2008, receiving net proceeds of $53.9 million for the issuance of 7.0 million shares of our common stock. The net proceeds were initially used to pay down our long-term debt due under the senior credit agreement.

As discussed in Note 2, on October 1, 2008, we sold our wholly-owned subsidiary, Pantwist, LLC ("Pantwist"), for $42.7 million ($40.1 million net of certain closing adjustments and broker fees).

As a direct result of the common stock issuance and sale of Pantwist, we fully repaid our long-term debt and terminated our subordinated debt agreement, which had an 8.50% interest rate. As discussed in Note 4, our borrowing base is $60.0 million under the senior credit agreement. We intend to draw down the available borrowings to fund our capital development program as previously discussed under "Drilling Capital Development Update", for selective acquisitions and for general corporate purposes.

At September 30, 2008, our cash balance was $11.5 million. As shown in the pro forma information in the consolidated balance sheets and further discussed in Note 2, after the completion of the Pantwist sale and paydown of long-term debt, our pro forma cash balance is $6.8 million. At September 30, 2008, our cash balance along with the balances for accounts payable and accrued liabilities were higher than normal as we waited to complete the sale of Pantwist, LLC on October 1, 2008.

For the three months ended September 30, 2008, we generated cash from operations of $2.7 million, which is a $1.6 million increase as compared to the prior year quarter of $1.1 million. The $1.6 million increase is attributed to higher revenues partially offset by higher operating expenses, as further discussed under "Results of Operations."

During October 2008, we sold a previously purchased financial contract covering July 2010 through December 2010 consisting of price floors for $0.6 million. All costless collars and other price floor contracts, as discussed in Note 5, remain in place. The lead lender for our senior debt agreement, Union Bank of California, N.A., is the counterparty to all remaining derivatives.

As discussed in Note 12, as of October 31, 2008, Kel-Tex Electric, Inc. paid Cano its full insurance policy limits of $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. This $6.0 million has been fully expended to cover the settlements discussed in Note 12.

We believe the combination of cash on hand, cash flow generated from operations, expected success of prior capital development projects and available debt is sufficient to finance our operations, contractual obligations and capital expenditure program (as previously discussed in the section titled "Drilling Capital Development Update") through June 30, 2009.

On December 28, 2007, our universal shelf registration statement was declared effective by the SEC for the issuance of common stock, preferred stock, warrants, senior debt and subordinated debt up to an aggregate amount of $150.0 million. After the issuance of common stock on July 1, 2008, we have $96.0 million of availability under this registration. We may periodically offer one or more of these securities in amounts, prices and on terms to be announced when and if the securities are offered. At the time any of the securities covered by the registration statement are offered for sale, a prospectus supplement will be prepared and filed with the SEC containing specific information about the terms of any such offering. We have no immediate plans to utilize the universal shelf registration statement.

Historically, our primary sources of capital and liquidity have been issuance of equity securities, borrowings under our credit agreements, and cash flows from operating activities.

Results of Operations

For the quarter ended September 30, 2008 ("current quarter"), we had income applicable to common stock of $11.8 million, which was $13.0 million higher as compared to the $1.2 million loss applicable to common stock incurred for the quarter ended September 30, 2007 ("prior year quarter"). Positive factors included increased revenues of $4.3 million, unrealized gains on commodity derivatives of $24.7 million and higher income of $0.8 million from discontinued operations. These positive factors were partially offset by higher operating expenses of $8.2 million, and higher realized losses on commodity derivatives of $0.8 million.

These items will be addressed in the following discussion.

Operating Revenues



The table below summarizes our operating revenues for the quarters ended
September 30, 2008 and 2007.



                                      Quarter Ended September 30,       Increase
                                         2008              2007        (Decrease)
Operating Revenues (In thousands)   $        10,946    $       6,587   $     4,359
Sales
† Oil (MBbls)                                    73               56            17
† Gas (MMcf)                                    194              239           (45 )
† Total (MBOE)                                  105               96             9
Average Price
† Oil ($/ Bbl)                      $        111.88    $       72.42   $     39.46
† Gas ($/ Mcf)                      $         14.04    $       10.25   $      3.79

The current quarter operating revenues of $10.9 million represent an improvement of $4.3 million as compared to the prior year quarter of $6.6 million. The $4.3 million improvement is primarily attributable to higher prices received for crude oil and natural gas sales of $3.3 million and $0.8 million, respectively, and higher oil sales of $0.8 million, partially offset by lower gas sales of $0.6 million. The higher oil sales were primarily attributed to the development activity at the Cato Properties, as previously discussed under the "Drilling Capital Development Update." The decreased gas sales pertain primarily from the Barnett Shale production from our Desdemona Properties due to reduced development activity and lower gas production from our Panhandle Properties due to normal decline, partially offset by higher gas production from the Cato Properties due to the aforementioned development activity.

The average price we received for crude oil sales is generally at or above market prices received at the wellhead (other than at the Cato Properties). The average price we receive for natural gas sales is approximately the market price received at the wellhead, adjusted for the value of natural gas liquids, less transportation and marketing expenses.

As discussed in Note 5, we have commodity derivatives in place that provide for $80 to $85 crude oil floor prices and $7.50 to $8.00 natural gas floor prices. If crude oil and natural gas NYMEX prices are lower than the floor prices, we will be reimbursed by our counterparty for the difference between the NYMEX price and floor price.

Operating Expenses

For the current quarter, our total operating expenses were $15.8 million, or $8.2 million higher than the prior year quarter of $7.6 million. The $8.2 million increase resulted from an impairment of long-lived assets of $3.5 million, increased lease operating expenses of $2.5 million, higher general and administrative expenses of $1.2 million, higher production and ad valorem taxes of $0.6 million and higher depletion and depreciation expense of $0.4 million.

During the current quarter, we have recorded a pre-tax $3.5 million impairment on our Corsicana oil and gas properties. 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 proven undeveloped reserves within the next five years. The fair value was determined using estimates of future production volumes, prices and operating expenses, discounted to a present value.

Our lease operating expenses ("LOE") consists of costs of producing crude oil and natural gas such as labor, supplies, repairs, maintenance, and utilities. For the current quarter, our LOE was $5.1 million, which is $2.5 million higher than the prior year quarter. For the current quarter, our LOE per BOE, based on production, was $45.93 as compared to $25.86 for the prior year quarter. We have incurred higher LOE due to increased workover activities at the Panhandle Properties, higher electricity costs and increased downhole chemical treatments. The workover

activities pertained to returning wells to production and are expected to result in increased production in future months. In general, secondary and tertiary LOE is higher than companies developing primary production because fields are more mature and typically produce less oil and more water. We expect the LOE per BOE to decrease during the 2009 Fiscal Year as we have successfully negotiated service rate decreases with vendors and expect production increases from the waterflood and EOR development activities we have implemented and are implementing as discussed under the "Drilling Capital Development Update."

Our general and administrative (G&A) expenses consist of support services for our operating activities and investor relations costs. For the current quarter, our G&A expenses totaled $4.9 million, which is $1.2 million higher than the prior year quarter of $3.6 million. The primary reasons for the $1.2 million increase were higher legal expenses pertaining to the fire litigation as discussed in Note 12; increased stock compensation expense due to the issuance of restricted shares and stock options as discussed in Notes 6 and 7, respectively; and increased payroll costs.

For the current quarter, our production and ad valorem taxes were $1.1 million, which is $0.6 million higher than the prior year quarter. The increase is attributable to higher revenues and increased ad valorem taxes due to notification of revisions in tax property valuations by taxing authorities for the 2008 calendar year. Therefore, the current quarter includes higher tax rates for the current quarter plus a charge for applying the rates to the first six months of the 2008 calendar year.

For the current quarter, our depletion and depreciation expense was $1.2 million, or $0.4 million higher than the prior year quarter. This includes depletion expense pertaining to our oil and gas properties, and depreciation expense pertaining to our field operations vehicles and equipment, gas plant, office furniture and computers. For the current quarter, our depletion rate pertaining to our oil and gas properties was $10.41 per BOE, as compared to prior year quarter of $7.18 per BOE due to higher rates for our Cato and Panhandle Properties based on our reserve redetermination at June 30, 2008.

Interest Expense

The interest expense we incurred in the current quarter of $0.1 million is comparable to the prior year quarter. Our interest expense for the current and prior year quarters is impacted by $0.3 million and $0.5 million, respectively, of interest cost that was capitalized to waterflood and ASP projects as discussed under the "Drilling Capital Development Update."

Unrealized Gain (Loss) on Commodity Derivatives

As discussed in Note 5, we have entered into financial contracts to set price floors for crude oil and natural gas, and to set price ceilings for crude oil. For the current quarter, we recorded an unrealized gain of $24.2 million to reflect the fair value of the commodity derivatives as of September 30, 2008. For the prior year quarter, we recorded an unrealized loss of $0.5 million. By their nature, these commodity derivatives can be highly volatile to our earnings. A five percent change in these prices for our derivative instruments can impact earnings by approximately $0.1 million.

Realized Gain (Loss) on Commodity Derivatives

As discussed in Note 5, during the current year quarter, we incurred a realized loss on our commodity derivatives amounting to $0.6 million. For the prior year quarter, we had a realized gain of $0.3 million. If crude oil and natural gas NYMEX prices are lower than the floor prices, we will be reimbursed by our counterparty for the difference between the NYMEX price and floor price. Conversely, if crude oil and natural gas NYMEX prices are higher than the ceiling prices, we will pay our counterparty for the difference between the NYMEX price and floor price.

Income Tax Benefit

For the current quarter, we recorded an income tax expense of $8.1 million as compared to an income tax benefit of $0.1 million during the prior year quarter. Both quarterly tax amounts include taxes related to discontinued opeartions. The change is a direct result of the change in taxable income and an increase in the current quarter's state tax rate, resulting in an aggregate rate of 39%. The income tax rate for the prior year quarter was 32%.

Preferred Stock Dividend

The preferred stock dividend for the current quarter of $0.9 million is comparable to the prior year quarter.

Income from Discontinued Operations

For the current and prior year quarters, we had income from discontinued operations of $1.4 million and $0.7, respectively. This represents the income attributable to the divested Pantwist operations as discussed in Note 2.

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.

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.