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                                     PART I
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ITEM 1: BUSINESS

The following discussion contains forward-looking statements which involve risks
and uncertainties. Such forward-looking statements include, but are not limited
to, statements regarding future events and the Company's plans and expectations.
The Company's actual results may differ significantly from the results discussed
in the forward-looking statements as a result of certain factors including, but
not limited to, those discussed herein. See "Forward-Looking Statements."


Overview

The Company is in the business of developing and marketing energy-related
technologies. The Company has developed a patented technology which it refers to
as the LFC Process. The LFC Process is intended to convert and upgrade low-rank
coal into a coal substitute and a hydrocarbon liquid. The LFC Process is
intended to produce two products called process derived fuel and coal derived
liquids, and at the same time reduce the PDF's pollution potential when it is
subsequently burned for fuel. The Company believes the LFC Process could upgrade
a significant portion of the world's abundant low-rank coal reserves into coal
and petroleum-based products which could provide cost-effective compliance with
certain environmental legislation and regulations including the Clean Air Act
and other current and possibly future U.S. and international environmental
regulations or concerns.

The LFC Process involves heating coal under carefully controlled conditions to
refine it into alternative fuels. The Company believes many existing users of
coal in the U.S., such as electric utilities, face costly capital expenditures
to modify their coal-powered electricity producing facilities to comply with the
Clean Air Act. In the opinion of the Company, the Clean Air Act impacts over 100
coal fired electrical generating plants in the U.S. and, by the year 2000,
requires many major U.S. power plants to achieve specified reductions in
pollution. The Company believes many countries outside the United States, who
currently generate much of their electricity from burning coal and who have
substantial low rank coal reserves, could use the LFC Process to provide a more
cost-effective and less environmentally damaging fuel source for the production
of power.

In 1989, the Company contributed the LFC Process to TEK-KOL. TEK-KOL currently
consists of the Company and Bluegrass Coal Holding Company ("Bluegrass") a
subsidiary of Zeigler Coal Holding ("Zeigler"). Zeigler is one of the largest
coal companies in the United States. The LFC Process has been used to produce
PDF and CDL for test burning at the Demonstration Plant owned by the ENCOAL
Corporation (a subsidiary of Bluegrass) in Gillette, Wyoming. To date the
Demonstration Plant has produced approximately 114,900 tons of PDF and 116,100
barrels of CDL, and has shipped over 83,500 tons of PDF to seven electric
utilities in six states, and 104,000 barrels of CDL to eight industrial users in
seven states. The purpose of the Demonstration Plant, which was originally
intended to operate for two years, was to demonstrate the validity of the LFC
Process. The Demonstration Plant was constructed pursuant to an agreement
between the U.S. Department of Energy and ENCOAL Corporation, a Shell Mining
Company ("SMC," now called Bluegrass) subsidiary, as part of the U.S.
government's "Clean Coal Technology Program." The Company believes the operation
of the Demonstration Plant from 1995 through the third quarter of 1997, when its
operations were suspended, has provided invaluable design data and engineering
parameters to assist in the commercial scale development of the LFC Process. If
the Demonstration Plant does not resume operations, then the possibility of
having other third parties construct a suitable substitute would be explored.
There could be a material adverse impact on the Company if the Demonstration
Plant does not resume operation or if a substitute testing plant is not
completed.

The LFC Process is still in development. PDF produced at the Demonstration Plant
has been sold and shipped to customers for testing and CDL has been sold to a
number of users. Although the Company believes it has completed development of
the LFC Process, additional development to test and demonstrate aspects and uses
of the LFC Process will be necessary before the value (if any) of its use on a
large scale commercial basis can be verified. There can be no assurance these
development issues will be successfully concluded or that the LFC Process will
be licensed or sold commercially, or if sold, will generate revenue or profits
for the Company.

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The Company intends to license the LFC Process to electric utilities, coal
producers, steel companies, foreign governments or agencies thereof, or
affiliates of these parties. The Company believes that licensing the LFC Process
will lead to its optimum use because of the substantial capital expenditures and
time required to construct and operate a plant using the LFC Process.

The OCET Corporation, a wholly owned subsidiary of the Company, is also
developing another energy-related technology referred to as the OCET Process.
The OCET Process is designed to deasphalt crude oil resid produced in oil
refining in order to increase the efficiency of crude oil refineries. Resid is
the residue remaining after processing crude oil in a refinery to produce liquid
fuels and lubricants. The OCET Process is still in the development stage, and
will require substantial research and development before it is ready (if ever)
for commercial use. The Company has another wholly owned operating subsidiary,
AMS. AMS designs and produces custom automated assembly equipment primarily for
manufacturers in the medical, automotive and High-Tech (consisting of computer,
electronics and communications) industries.


TEK-KOL Partnership

TEK-KOL owns all rights, title and interest in the LFC Process, except for a
non-exclusive license granted by the Company prior to the formation of TEK-KOL
to Rosebud Energy Corp. for LFC process cogeneration plants with an aggregate
capacity of 350 MW. The partners in TEK-KOL are the Company and Bluegrass.
TEK-KOL was established in 1989 with the original partner being SMC. In 1992,
all of the assets of SMC were purchased by Zeigler. The TEK-KOL Partnership
Agreement, as amended, currently provides for the distribution of 75% of certain
TEK-KOL cash receipts to the Company and 25% to Zeigler, until the Company
receives $2 million. Thereafter, cash from operations, (if any) is to be
distributed 50% to the Company and 50% to Zeigler. TEK-KOL is marketing the LFC
Process to obtain licensees, joint venture partners, strategic and other
relationships. Except for the license issued to SMC for the Demonstration Plant
and other plants to be built by SMC and a similar license issued to the Company
for its sole projects, TEK-KOL does not have any agreements to license the LFC
Process. TEK-KOL operates in accordance with a budget. All of the costs of
TEK-KOL are split equally between Bluegrass (formerly SMC) and the Company. The
Company expects TEK-KOL's budget for 1998 to be approximately $1,500,000 to
$2,000,000. However, there can be no assurance that the Company's obligations
will not be greater than one half of that amount. The Company intends to finance
its obligations from the sale of equity, assets and debt securities. There can
be no assurance that the Company will be able to fund its obligations pursuant
to the TEK-KOL Partnership agreement. In the event that the Company was unable
to fund its obligations under the TEK-KOL Partnership Agreement this could have
a material adverse impact on the business and operations of the Company.


LFC Process

The LFC Process is specifically designed to process subbituminous (low-rank) or
lignite coal which has a high moisture content. PDF is designed to be a less
polluting solid fuel with a higher Btu, or heat value, than the coal it was
refined from, and with significantly lower moisture. PDF has higher ash, a
higher fixed carbon and lower organic sulfur than the parent coal. CDL is a
low-sulfur hydrocarbon liquid. Based on operations at the Demonstration Plant,
the Company believes each ton of coal should produce approximately one-half ton
of PDF and one-half barrel of CDL, although differing raw material and operating
conditions may effect these estimates.

To process the coal, the LFC Process uses a drying/partial pyrolysis technology,
which uses low-rank coal as a feedstock. Pyrolysis is a process whereby organic
compounds are subjected to very high temperatures. The LFC Process is a mild
gasification technology that employs a series of pyrolysis zones to produce
solids and gas, and a condensation system to produce liquids. The LFC Process
has been used at the Demonstration Plant which has produced and shipped to
customers over a hundred tons of PDF for test burning and over a hundred
thousand barrels of CDL. The Company believes the operation of the Demonstration
Plant has provided key operational and engineering design data for the LFC
Process which it believes may assist in completing the final stages of
development of the LFC Process.

The Company believes four key factors in the LFC Process differentiate it from
other coal cleaning, liquefaction, or gasification technologies. First, the
process simultaneously produces solids and liquids.

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Second, the control system regulates the coal heating rate and temperature
level to control the governing kinetics of gasification and stabilization
reactions. Third, the PDF can be stabilized and is less likely to self-ignite.
Fourth, for the purpose of controlling the gasification conditions (to obtain
the desired co-products), computer models of coal reaction kinetics, sensors,
and servo-mechanisms can be incorporated into the control system.

The Company's marketing efforts are in part based on the Company's belief that
low-grade (or low-rank) coals of the world are relatively disadvantaged in the
marketplace compared to higher-rank bituminous coals. Low-rank coals generally
have higher water content which makes them more expensive to transport to
distant markets. Additionally, their lower heat value can make them a less
efficient boiler fuel. The Company estimates the transportation cost component
of the coal's delivered price can be over 3-5 times the cost of the coal at the
mine. SGI expects PDF and CDL can reduce transportation costs by removing water,
and economically producing lower sulfur, lower water content, cleaner burning
coals along with potentially valuable co-product oils and liquids, and therefore
such refineries' products will be able to compete against high-grade coals.
There can be no assurance these objectives will be achieved.


LFC Process Demonstration Plant

In 1989, ENCOAL Corporation, which at the time was a Shell Mining Company
subsidiary, and the U.S. Department of Energy ("DOE") jointly committed to fund
one-half each of the costs to construct, own and operate, for two years, a
"Clean Coal Demonstration Plant" using the LFC Process at the Buckskin Mine near
Gillette, Wyoming. Several amendments of the original agreement with the DOE
extended the operations and funding of the Demonstration Plant to March 1997.
TEK-KOL licensed the LFC Process to SMC Mining for use at the Demonstration
Plant. Construction of the Demonstration Plant began in 1990 and was completed
in 1995 when it began shipping PDF and CDL to customers for test burning. The
Demonstration Plant was not expected to, and did not, produce any licensing
royalties to the Company.

In November 1992, Zeigler Coal Holding Company ("Zeigler") purchased Shell
Mining Company and its assets, including ENCOAL Corporation and the
Demonstration Plant. Zeigler operated the Demonstration Plant through the third
quarter of 1997 at which time the operations of the Demonstration Plant were
suspended. Suspending operations of the Demonstration Plant may have a material
adverse impact on the marketing of the LFC Process.

In late 1996 and early 1997, the ENCOAL Corporation, a subsidiary of Zeigler
applied for various air quality, industrial siting, land quality and land swap
permits with the state of Wyoming and certain agencies of the U.S. government in
contemplation of construction of an LFC Process plant. Mitsubishi International
Corporation and the ENCOAL Corporation, a Zeigler subsidiary, executed an
engineering, procurement and construction agreement on December 30, 1996, for
the construction of a $460 million LFC Process plant. Although this agreement
was subsequently terminated, Zeigler is continuing to develop an LFC Process
plant at that location. The Company was not a party to the agreement that was
terminated. The Company currently has no obligation to assist in funding the
continued development of an LFC Plant at North Rochelle. There can be no
assurance that any plant will be developed by Zeigler or others. The termination
of this agreement to construct an LFC Process plant may have a material adverse
impact on the business and operations of the Company.

Test burns to date, based on the Company's analysis, indicate PDF is a viable
fuel which can be used with minimal modification of the coal burning equipment.
The Company believes PDF can be a means for helping utilities meet the
requirements of the Clean Air Act. There can be no assurance these test results
will be duplicated in a future commercial facility, if any, using the LFC
Process.


Markets

The Company believes the principal markets for PDF will be the electric utility
market where utilities may burn coal to generate electricity, and in the
non-coking coal metallurgical market which produce steel and metals. TEK-KOL
currently believes future PDF production from an LFC Process plant could be sold
into the utility

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market and the metallurgy market. There can be no assurance the
Company's beliefs will prove to be accurate.

CDL from the Demonstration Plant has in general been sold into the residual fuel
oil market. Of the approximately 5,010,600 gallons of CDL that have been
produced by the ENCOAL Demonstration Plant and sold, the vast majority has been
sold into the residual fuel oil market to oil distributors who have blended the
CDL or sold it as straight fuel oil for use in industrial boilers. Other
purchasers of CDL have included a coal tar chemical company and a steel
manufacturer. While the Company has completed development work to determine
CDL's composition, significant additional development is required. The Company
believes CDL may have more potential when further refined into separate
products. No assurance can be given that any market for PDF and CDL will
develop.

PDF Electric Utility Markets. The Company believes power plants operated by
utilities meeting the following criteria will be the "best potential" markets
for PDF. Boilers requiring low ash-fusion coal (primarily cyclone and wet bottom
boilers); boilers using high-Btu fuel; utilities desiring to switch to
low-sulfur coal to meet Clean Air Act compliance levels; and utilities with
acceptable transportation economies. There can be no assurance any of these
utilities would elect to use PDF once development is completed.

A number of factors could have a material impact on the size and value of the
utility market for PDF. The Company believes the potential impact of the Clean
Air Act on the utility industry could present marketing opportunities for PDF.
If environmental regulations become stricter, the desirability for PDF may
increase. The Company believes the potential for reduced emissions increases the
likelihood PDF could be marketed successfully. A full or partial repeal of the
Clean Air Act would likely have a material adverse impact on the Company and the
market for PDF in the United States.

PDF Metallurgical markets. While the Company believes the U.S. electric utility
market is the largest potential market for PDF, based on the current economics
of coal burning utilities, the Company also believes a relatively small, but
potentially growing market for non-coking metallurgical coals could provide an
opportunity for sales of PDF. Potential PDF metallurgical markets could occur in
the steel industry, where the Company believes demand for coke substitutes is
increasing. In steel making, the Company believes environmental constraints on
coke production and the lower limits on permissible emissions may motivate
development of new technologies to replace the traditional combustion of blast
furnaces and coke ovens.

CDL Markets. The Company believes current industrial residual fuel oil markets
in the U.S. will not pay enough for CDL as a residual fuel to make it worthwhile
to sell into that market. Enhanced CDL-derived products are being developed by
the Company with the goal of providing increased economic returns. While these
enhanced CDL products are not yet completely defined, progress has been made in
developing upgraded CDL products. Portions of the upgrading process have been
identified by the Company and include centrifugation to remove entrained solids,
distillation to collect crude cresylic acids, as an asphalt additive and the
sale of the remaining crude CDL to fuel oil markets. The Company will require
significant additional funding to further its research, development and testing
before enhanced CDL products could be available for commercial use.

CDL upgrading efforts are currently focused on domestic and international
markets that the Company believes may be more commodity based, and less
sensitive to limited numbers of fixed end users. These CDL markets are aimed at
transportation fuels combined with specialty chemicals with potential large
volume acceptance. There can be no assurance the Company will develop any
upgraded CDL products, that any markets will accept or use CDL, or that it will
produce revenues or profits for the Company.


OCET Process and Strategy

Another energy-related technology which is being developed by the Company
through its wholly-owned subsidiary, the OCET Corporation, is the OCET Process.
The OCET Corporation ("OCET") is a development stage Delaware corporation. OCET
is developing a technology which it believes can deasphalt petroleum residuum,
or resid, so it can be more easily or further refined (the "OCET Process").

<PAGE>

In laboratory tests, both petroleum resid and heavy crudes have been
successfully deasphalted using lab scale continuous prototype processing
equipment. The results of these laboratory tests have demonstrated the ability
to produce deasphalted oil which OCET believes is comparable in quality and
yield to that produced by commercial solvent deasphalting processes. There can
be no assurance the results of such laboratory tests will be proved in actual
commercial scale developments, or that any commercial use will be made of the
OCET Process.

The Company's principal efforts in commercializing the OCET Process are intended
to focus on licensing the technology to oil refineries, oil companies, and other
parties with related interests. Construction and operation of a commercial scale
facility using the OCET Process is dependent upon funding from the oil refinery,
oil company, or other third parties. OCET believes there has been a shift of
crude oils over time to being higher in resid volume and contaminant levels, and
therefore the need for successful deasphalting technology has increased. Experts
in the industry, employed by the Company, believe that the quality of crude oils
has declined and has a greater amount of asphaltenes, nickel, vanadium, and
other contaminants, which results in a greater amount of resid being produced
from refining operations.

The OCET Process uses a solvent additive to destabilize the crude oil,
followed by electrochemical processing to separate the asphaltenes, metals and
unwanted contaminants contained in the resid in order to produce a higher
quality liquid which OCET believes could be used in refinery processes. The
electrochemical processing distinguishes the OCET Process from other
deasphalting processes known to the Company, and OCET believes will provide an
additional method for controlling the rate, selectivity and efficiency of the
separation. The OCET Process as currently structured does not require high
temperatures or pressures.

OCET and SGI are currently in the process of attempting to construct a model
process development unit which would be capable of measuring OCET Process
performance. Concurrently, analytical methods are also being developed in an
effort to analyze feedstocks to measure and optimize process performance.
Management initially believed that substantial additional funding to complete
the process development unit would be required. However, the additional
equipment necessary to complete the development unit has been acquired for much
less than anticipated and future funding necessary for completion of the
development unit is currently considered insignificant.

OCET believes domestic and worldwide demand for crude oil and refining products
is expected to increase, and worldwide refining capacity is also expected to
increase. OCET believes new oil refineries are likely to be called upon to meet
increased worldwide demand for transportation fuels and to supply both
distillate and residual fuels with decreased sulfur levels to decrease
pollution.

The target application for the OCET Process has been the upgrading of refinery
resid to produce high quality lube oil blend stock, feedstocks for refinery
catalytic upgrading processes, hydrocracking or hydrotreating and boiler grade
coker feed because the liquid product could be reduced in asphaltenes, metals,
sulfur, nitrogen, carbon residue and other contaminants. OCET believes there are
other potential markets, including deasphalting heavy crude oil at the well
site, upgrading crude oil before introduction into the crude distillation tower
at the refinery, near complete removal of metals from deasphalted oils, removal
of sulfur compounds from diesel and gasoline, viscosity reduction as oil is
being produced out of the ground, cleaning of used motor oil to remove metals
and other contaminants, and removal of hydrocarbons and metals such as selenium
from wastewater.

On April 14, 1997, OCET and the U.S. Department of Energy executed a Cooperative
Research and Development Agreement ("CRADA") to jointly analyze certain
parameters of the OCET Process. The CRADA is intended to allow petroleum experts
in the DOE to consult with SGI while protecting SGI's proprietary information.

The OCET Process is expected to compete with alternative methods for
conversion of resid including thermal processes, solvent extraction processes
and catalytic processes. The primary method for upgrading resid is delayed
coking, which exposes resid to high enough temperatures to break apart some of
the chemical bonds to produce gases, liquids and solid coke.

There can be no assurance the OCET Process will be determined to be commercially
viable, or will be developed to the point where it can be determined to be
commercially viable, or that there will be a market for the

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OCET Process, or, if a market develops, OCET will license its technology or
otherwise produce revenue from the OCET Process or any other enterprise or
technology development.

The OCET Process is still in development and has not been licensed or used in
either a pilot plant or on a commercial scale. The OCET Process will require
significant additional research and development, including substantial
additional funding to finish development of the process and demonstrate its
potential (if any) for commercial use. There can be no assurance such efforts
will be successfully completed. At the present time, OCET has no agreements with
any oil refinery or other party to use the OCET Process in a commercial or large
scale testing facility.


Patents and Proprietary Technology

To date, TEK-KOL has been issued five patents and one patent pending in the
United States, which relate to various aspects of the LFC Process. Patent
#5,601,692 was issued in February 1997. Patent #5,401,364 was issued in March
1995; Patent #5,372,497 was issued in December 1994; Patent #5,582,807 was
issued in December 1996; Patent #5,547,548 was issued in August 1996. TEK-KOL
filed a patent application in October 1995 for a lean fuel combustion control
method which is pending. OCET filed a patent application in September 1994 for
the OCET Process, which was allowed in January of 1998. AMS owns one patent
jointly with Ethicon, a customer, however, AMS does not believe this patent is
critical for the operation of its business.

TEK-KOL has non-exclusive worldwide rights to license the use of the MK Dust
Control System pursuant to the License Agreement with Bluegrass. There can be no
assurance any additional patents will be issued to TEK-KOL as a result of
TEK-KOL's pending applications, or, if issued, such patents combined with the
existing TEK-KOL patents will be sufficiently broad to afford protection against
competitors using similar technology. The Company's success will depend in large
part on its ability and that of TEK-KOL to obtain patents for the LFC Process
and related technologies, if any, to defend patents once obtained, to maintain
trade secrets and to operate without infringing upon the proprietary rights of
others, both in the United States and in foreign countries. TEK-KOL also has
foreign patents pending for certain elements of the LFC Process.

There can be no assurance any patents issued to TEK-KOL, the Company, or OCET
will not be challenged, invalidated or circumvented, or that the rights granted
thereunder will provide competitive advantages to the Company. Litigation over
patent or other intellectual property claims could result in substantial costs
to the Company. The Company is required by the TEK-KOL Partnership Agreement to
contribute to the costs of prosecuting and defending all infringement claims
necessary to enforce TEK-KOL's rights or to determine the scope and validity of
others' proprietary rights. U.S. patents do not provide any remedies for
infringement occurring before a patent is granted. Because patent rights are
territorial, the Company or TEK-KOL may not have an effective remedy against use
of their patented technology in any country in which TEK-KOL or the Company does
not, at the time, have an issued patent.

The commercial success of the Company may also depend upon avoiding the
infringement of patents issued to competitors. TEK-KOL owns all of the
technology relating to the LFC Process. If competitors prepare and file patent
applications in the United States claiming technology also claimed as
proprietary by TEK-KOL or the Company, the Company may be forced to contribute
to the cost of participating in interference proceedings declared by the U.S.
Patent office ("PTO") to determine the priority of the invention. Such
proceedings could result in substantial costs to the Company, even if the
outcome is favorable to the Company. An adverse outcome of such proceedings
could subject the Company to significant liabilities to third parties and could
require TEK-KOL and/or the Company to license disputed rights from third parties
or cease using the infringing technology. Although the Company believes its
current and proposed activities do not and will not infringe upon patents for
competing technologies, there can be no assurance the Company's belief would be
affirmed in any litigation over any patent or that the Company's future
technological developments will be outside the scope of these patents. A U.S.
patent application is maintained under conditions of confidentiality while the
application is pending in the PTO, so the Company cannot determine the
inventions being claimed in pending patent applications filed by its
competitors. If competitors infringe on TEK-KOL or Company patents which are
pending but not yet issued, TEK-KOL and the Company will not be able to pursue
infringement claims against them unless the infringement continues after such
patents are issued.

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The Company also relies on certain proprietary information which may not be
patentable. Although the Company has taken steps to protect its proprietary
information, in part through the use of confidentiality agreements with certain
employees, consultants and contractors, there can be no assurance these
agreements will not be breached, the Company would have adequate remedies for
any breach, or the Company's proprietary information will not otherwise become
known or be independently developed or discovered by others including its
competitors.


Governmental Regulation

The LFC Process, as it is proposed to be used in the operation of a coal
refinery plant will likely be subject to numerous federal and state regulations.
Any United States LFC plants that may be constructed will likely be owned by
others since the Company does not now have and is not expected in the future to
have the financing necessary to develop, construct or operate such plants. LFC
Process plants will likely require numerous permits, approvals and certificates
from appropriate federal, state and local governmental agencies before
construction of any such facility may begin, and will be subject to periodic
maintenance or review requirements once any such facilities begin production.
Such permits and regulations include: (i) air quality; (ii) wastewater
discharge; (iii) land quality; and (iv) hazardous waste treatment storage and
disposal. There can be no assurance that such approval will be granted to any
licensees of the LFC Process in the event a plant is proposed to be constructed
and operated using the LFC Process. In addition, there can be no assurance
future domestic or international governmental regulations will not change and
the necessary permits and approvals for any future commercial-scale production
facilities will not be prohibitively expensive or difficult to obtain. Any
failure by any licensee of the LFC Process to obtain required regulatory
approvals, or any substantial delay in obtaining such approval, could have a
material adverse effect on the Company.

Mine Health and Safety Administration ("MHSA") regulations and approvals may be
applicable to any use of the LFC Process at a plant constructed for such use.
The Demonstration Plant in Wyoming has operated under the oversight of the MHSA
since construction began. The Company believes the ideal location for an LFC
Process plant will be on the grounds of or adjacent to a coal mine to minimize
transportation costs.

The Clean Air Act and amendments specify certain air emission requirements for
electrical utility companies and industrial coal users. The Company believes the
Clean Air Act is now, and will in the future be, a significant factor in
creating demand and a market in the U.S. for the LFC Process. The Company
believes electric utilities and industrial coal users who use the LFC Process
will be subject to the Clean Air Act, and compliance with such regulations could
be fully or partially met through the use of the LFC Process. Beginning on
January 1, 2000, Phase II of the Clean Air Act imposes a permanent cap on sulfur
dioxide emissions and requires nitrogen oxide reductions. A full or partial
repeal of the Clean Air Act could have a material adverse impact on the Company.
The Company is unable to predict future regulatory changes and their impact on
the demand for the LFC Process.


Competition

The principal markets for PDF and CDL are in the energy industry, which is
intensely competitive. There are many companies engaged in research into ways to
clean or convert coal into a more acceptable fuel or other commercially viable
products. Many of TEK-KOL's existing or potential competitors have substantially
greater financial, technical and human resources than TEK-KOL and may be better
equipped to develop, test and license coal refining technologies. In addition,
some of these companies have extensive experience in operating refining plants
and many of these companies have extensive experience in operating coal burning
plants. These companies may develop and introduce coal refining technologies
competitive with or superior to those of TEK-KOL prior to any market acceptance
for the LFC Process or other technologies developed by the Company or its
subsidiaries.

The relative speed with which TEK-KOL markets the LFC Process and enters into
licenses or other agreements with third parties who, thereafter construct, own
and operate a plant using the LFC Process and their success in supplying
processed coal products, are expected to be important competitive factors.
TEK-KOL expects principal competitive factors may include, among other things,
how economically LFC Process coal products

<PAGE>

can be produced, at what quality levels and how fast demand for such products
develops, compliance with environmental standards, transportation costs, cost
comparisons to other energy fuels, and the strength of any patents on the LFC
Process or other related technologies.

The demand, if any, by coal-fired electrical generation facilities for processed
coal products derived from using the LFC Process may also be materially impacted
by several competing fuels and other costs, such as natural gas and alternative
energy sources including but not limited to hydroelectric power, synthetic
fuels, solar power, wind power, wood, geothermal, waste heat, solid waste and
nuclear sources. The Company believes other competitive factors which may
influence competition for TEK-KOL include the availability and cost of delivered
coal, the difference between the costs of other energy alternatives and coal
prices and availability, regulatory efforts to reduce pollution and other
emissions, regulatory incentives, if any, to utilize clean coal based energy
sources and the reliability and cost effectiveness of the LFC Process relative
to other competing technologies.

TEK-KOL's competitive position also depends upon its ability to attract and
retain qualified personnel, obtain patent protection or otherwise develop
proprietary products or processes and secure sufficient capital resources for
the period between development and testing of the LFC Process and any possible
introduction of the technology into the commercial market place.

The Company is aware of several entities in the U.S. and in foreign countries
which are engaged in producing clean-burning coal. These include the Rosebud
SynCoal Partnership, owned by indirect subsidiaries of Montana Power Company and
Northern States Power Company which owns a plant in Colstrip, Montana. Also,
KFX, Inc., a public company, is engaged in producing a clean coal product,
Carbontec, which produces upgraded coal at a pilot plant; Custom Coals,
International, which makes a clean coal product; Puron Co.; Cyprus, a coal
company, and SOSOI/FT. There can be no assurance TEK-KOL will be able to compete
successfully with any of these companies.


ASSEMBLY AND MANUFACTURING SYSTEMS, INC.

AMS, a wholly-owned subsidiary of the Company, is a supplier of custom made
precision assembly equipment. AMS designs and builds custom, automated assembly
systems marketed principally to manufacturers in three principal industries:
medical, automotive and High-Tech. These assembly systems integrate multiple
manufacturing functions often into a single custom production line built to the
customer's specifications.

Assembly functions integrated into products manufactured by AMS include:
material and component handling, dispensing and placement of film or liquid
adhesives, sealants or customer-formulated materials such as pharmaceuticals,
marking and encoding, assembly of components, riveting, swagging, inspection
functions including machine vision inspection, testing, data collection and
analysis. Completed AMS assembly systems may be from bench top size to almost a
hundred feet in length, and may incorporate all types of subsystems, including
robots, machine vision, conveyors, welders, mechanical tests, electronic tests
and others as specified by the customer. AMS believes it is well positioned to
capitalize on what it forecasts is an ongoing consolidation and growth in the
fragmented automation assembly market.

Automation system functions integrated into products manufactured by AMS are
generally computer controlled through custom software written by AMS, and
incorporate control, data handling, reporting and safety functions. The
completed automation systems are generally tested and accepted by the customer
at AMS prior to shipment and installation at the customer's site.

AMS believes that a majority of its current customers and future customers
purchase automation systems for several reasons including support of new product
introductions and start-up, labor cost reductions, increase in capacity,
increase in quality, and favorable return on investment and payback. AMS
customers may also choose to automate production of their products to reduce
costs and improve productivity on current products and to increase their quality
and improve facilities.

AMS believes it offers customers a number of competitive advantages over its
competitors including successful project execution, competitive pricing, systems
which meet specified performance criteria, engineering and manufacturing
expertise and experience and innovative machine concepts. The typical AMS
contract price is in excess of $500,000.

<PAGE>

Marketing and Sales

AMS employs three sales professionals and two to three applications engineers
and their support staff who are involved directly in marketing its services to
potential customers. AMS relies primarily on personal contact by its executive
and sales personnel to secure new customers and to market its products. AMS
regularly participates in local, regional and national trade show meetings in
its key industry groups. AMS believes personal contact by its sales and
engineering staff is critical to retain new customers.

AMS has targeted large, established manufacturing companies in the medical,
automotive and High-Tech industries as prospective clients. AMS targets
companies that need small manufactured equipment and devices, requiring
mechanical or electric mechanical assembly and test, or inspection with material
handling, as key accounts. To assist in marketing products and services, AMS
also works to develop new applications for target customers for their various
manufacturing needs.

As part of its current marketing focus, AMS is targeting Fortune 1000 businesses
with assembly contracts in the range of $750,000 to $1.5 million per project to
increase market share and benefit from economies of scale.

Major Customers

Sales revenue was derived primarily from contracts to manufacture assembly
equipment with three, four and two customers in 1997, 1996, and 1995,
respectively. Revenue from sales of automated assembly equipment accounted for
99%, 93% and 96% of the Company's consolidated revenues in 1997, 1996, and 1995,
respectively. In each of the past three years no single customer has accounted
for more than 10% of sales on a consistent basis. AMS does not have long term
contracts with any of its customers and expects that a small number of customers
will continue to account for a substantial portion of sales for the foreseeable
future. Due to the small number of annual projects attempted by AMS, a
significant performance problem with any one AMS project could have a material
adverse effect on AMS. There can be no assurance revenue from customers who
accounted for significant revenue in past periods, individually, or as a group,
will continue, or if continued, will reach or exceed historical levels in any
period.

Manufacturing

All design, engineering, fabrication, assembly and testing of AMS's products are
carried out at its facility in Simi Valley, California. Proprietary software and
in-house procedures are used to ensure the quality and timeliness of project
execution, and AMS's custom automation related software incorporates control,
data handling, reporting and safety features. AMS also uses state-of-the-art
computer-aided design practices to create the customized assembly processes for
its customers.

To manufacture certain of automation equipment, AMS uses subcontractors for
common industrial services such as machining, fabrication of welded structures,
painting and power coating on an as-needed basis. Manufacturing operations
include purchasing, receiving, cutting, machining, grinding, electrical
fabrication and testing, machine assembly and all other functions required to
complete the automated assembly product. When needed, AMS also employs a number
of subcontractors for special assembly operations including welding, power
coating, wire electric discharge machining and other unique operations.

AMS has implemented certain quality control procedures for its manufacturing
facility. AMS's quality control personnel regularly monitor the manufacturing
process and have initiated numerous procedures which assist in quality control.
AMS believes new customers, particularly Fortune 1000 customers with large
assembly projects, may impose additional quality control standards. It is
possible such customer or other quality control standards may require additional
substantial expenditures over a long period of time, or that AMS may determine
that such expenses are not cost-effective.

Raw Materials

The primary raw materials used by AMS in assembly systems include such items as
stock steel shapes, aluminum extrusions, billet and plate software. These raw
material items are converted by AMS into

<PAGE>

the needed support structures and are
custom-machined in house to be incorporated into the automated assembly systems
purchased by AMS customers. Raw materials used by AMS are generally standard
industry materials which AMS believes can be provided from multiple sources of
supply. AMS believes the most critical machine subsystems such as computers,
vision systems, part feeders, conveyors and robots are also common and have
multiple sources of supply. Up to approximately 75% of the AMS assembly system
components are purchased off the shelf. AMS does not have any long term
contracts with any of its raw material suppliers, and believes numerous
suppliers would be available in the event its current suppliers were not
available.

Competition

The Company believes competition in the automotive assembly industry is
fragmented, and that no single competitor dominates the industry. While AMS
competes with at least 85 other companies which are engaged in the automation
assembly business, AMS believes the majority of these competitors provide
assembly equipment for smaller projects, and cannot handle the larger projects
(over $250,000 in price) for which AMS is currently competing. AMS's principal
competitors in the 1997 fiscal year include Remmele Corp., Vanguard Automation,
and Bosch-Weldun Automation. Many of AMS's competitors have substantially
greater financial, marketing and technological resources than AMS.

The automation industry is characterized by rapid technological change, and
competitors may develop their automation products more rapidly than AMS. AMS
believes competition among automation companies is based primarily on price, the
speed and quantity of products produced, timely delivery, product quality,
safety, product innovation and assistance in marketing and customer service. The
competitive position of AMS will depend in part on AMS's ability to remain
current in automation manufacturing and to increase the innovation, speed and
reliability of its automated assembly processes. There can be no assurance
AMS will be able to compete successfully.

Backlog

As of December 31, 1997, AMS had a backlog of orders of approximately $1.3
million, compared to a backlog as of December 31, 1996, of approximately $2.8
million.

Liability Insurance

The medical, automotive, High-Tech and other products expose AMS to possible
product liability claims, if the use of such products results in personal
injury, death or property damage. AMS maintains product liability insurance in
the principal amount of $2 million through April 1998. There can be no assurance
such insurance will be adequate in terms and scope to protect AMS against
material adverse effects in the event of a successful claim, or that such
insurance will be renewed with acceptable terms and conditions.

Employees

The Company, including OCET, employs 20 full-time employees and AMS employs
approximately 33 full-time employees. None of the Company's or AMS's employees
are represented by a labor union or bound by a collective bargaining agreement.
The Company and AMS believe that they maintain positive relations with their
employees.


ITEM 2. PROPERTIES

The Company leases 5,500 square feet of office space at 1200 Prospect Street,
Suite 325, La Jolla, California 92037. The term of the lease expires in December
2000. In addition, the Company leases 5,080 square feet of laboratory space at
11588-20 and 21 Sorrento Valley Road, San Diego, California 92121 pursuant to a
lease which expires in May 2000. AMS leases 20,000 square feet of office and
manufacturing space at 2222 Shasta Way, Simi Valley, California 93065, which
includes 15,000 square feet of manufacturing space. The term of the lease
expires in October 1998. The Company and AMS believe their current facilities
will be adequate for their respective expected needs for the foreseeable future.

<PAGE>

ITEM 3. LEGAL PROCEEDINGS

The Company and its subsidiaries are from time to time involved in litigation
arising in the ordinary course of their respective businesses. The only lawsuit
currently pending against the Company is Walsh vs. AMS, filed on September 7,
1997, in the San Diego Superior Court. The Walsh case relates to events
occurring prior to the by the Company. The lawsuit asserts
claims, for among other things, breach of contract relating to a loan of
approximately $300,000. AMS has filed an answer denying liability and discovery
is proceeding. In the opinion of the Company, the pending litigation, if
adversely decided, should not have a material adverse effect on the Company.


ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted during the three months ended December 31, 1997, to a
vote of the shareholders.

<PAGE>
_______________________________________________________________________________

PART II
_______________________________________________________________________________


ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

The Common Stock of the Company is currently traded and prices are quoted on the
NASD OTC Bulletin Board under the symbol SGII. The following table sets forth
the high and low bid prices for SGI Common Stock during the periods indicated.
The prices represent bid quotations and do not include retail mark-ups,
mark-downs or fees, nor do they necessarily represent actual trades.

<TABLE>


                                   High             Low
                                  ______          _______
          1997
          <S>                     <C>             <C>

          First Quarter           $ 6.25          $ 4.19
          Second Quarter            4.31            1.88
          Third Quarter             3.22            1.03
          Fourth Quarter            2.38            1.09

          1996

          First Quarter           $ 3.44          $ 0.63
          Second Quarter           13.00            2.25
          Third Quarter             6.00            3.50
          Fourth Quarter            7.88            3.88

</TABLE>

As of March 2, 1998, the Company had approximately 2,200 stockholders of record,
and believes it has beneficial owners in excess of that number.

The Company has not declared any cash dividends on the Common Stock and does not
currently intend to pay any cash dividends on the Common Stock in the
foreseeable future.

The Company had the following sales of unregistered securities during the fiscal
year period ended December 31, 1997.

<PAGE>

In April 1997, the Company executed a funding agreement with certain foreign
accredited investors which provided for the sale of the Company's common stock
in three tranches of $1,000,000 each, pursuant to Regulation S. On May 30, 1997,
this agreement was modified and the Company issued 1,000 shares of $.01 par
value, 8% Convertible Preferred Series 97B stock and ten warrants to purchase
30,000 shares at $2.30 per share to four foreign accredited investors for an
aggregate $1,000,000. The 97B Preferred Shares accrued dividends at a rate of 8%
per annum and were cumulative. The dividend is only payable in common stock of
the Company. The warrants were immediately exercisable and expire on May 30,
2002. As of December 31, 1997, all the preferred shares had been converted into
756,006 common shares of the Company.

In October 1997, the Company was able to extend, exchange or convert
approximately $4.8 million in existing debt for new securities of the Company,
including common stock, warrants and revised, amended or new convertible debt
securities and also paid approximately $400,000 in existing debt. The Company
retired approximately $250,000 in existing 10%, 11% and 12% interest bearing
notes which were required to be paid by October 31, 1997, in exchange for
$250,000 of 12% convertible debentures due September 30, 1998, with a conversion
price of $1.20. The Company obtained an extension to September 30, 1998 of
approximately $3,428,000 of debt which was required to be paid by October 31,
1997, and, in connection therewith, agreed to grant warrants to purchase an
aggregate of 152,500 shares of common stock at an exercise price of $1.20 per
share for each quarterly period the debt remains unpaid. The warrants are
exercisable one year from the date of issuance. The Company retired an
additional $727,000 of existing 10%, 11% and 12% interest bearing notes which
were required to be paid by October 31, 1997, in exchange for $727,000 of 12%
convertible debentures due September 30, 1998, with a conversion price of $1.20.
In connection therewith, and in part as consideration for all interest due
through the maturity of the extended notes, the Company issued 95,439 shares of
restricted common stock. All of the securities issued in the debt restructuring
were issued to existing security holders of the Company, in reliance upon
exemptions from registration, pursuant to Section 3(a)(9) and 4(2) of the
Securities Act and Rule 5.06 promulgated thereunder. All debt holders were
"Accredited Investors" as defined in Regulation D.

On December 11, 1997, the Company issued 25,714 restricted common shares and two
warrants to purchase an aggregate of 37,714 common shares at $5.75 per share to
one purchaser pursuant to Section 4(2) of the Securities Act. The warrants were
exercisable one year from the date of issuance and expire on December 31, 1999.
The common shares and warrants were issued in exchange for current obligations
of approximately $116,000, and for claims against future collections on notes
held by the Company, as well as to acquire a 12% distributed net profits
interest in a potential cogeneration facility.

Between October 1, and December 31, 1997, the Company granted warrants to four
consultants to purchase 105,000 common shares, at exercise prices between $1.31
and $1.38 per share. Investment representations were obtained and the warrants
were issued pursuant to Section 4(2) of the Securities Act and Regulation D. The
warrants are exercisable one year from the date of grant and expire in November,
2002.

On December 31, 1997, the Company issued warrants to purchase 152,500 common
shares to accredited investors, pursuant to Regulation D. These warrants were
issued to certain debt holders in accordance with their agreements and contain
an exercise price of $1.20. The warrants are exercisable one year from the date
of grant and expire on December 31, 2002. The warrants were to existing security
holders of the Company in reliance upon exemptions from registration pursuant to
Section 3(a)(9) and 4(2) of the Securities Act and Rule 5.06 promulgated
thereunder.

On January 14, 1998, the Company granted incentive stock options, pursuant to
its 1996 Omnibus Stock Plan, exercisable for a total of 225,000 shares of common
stock at $0.843 per share to employees of the Company. The options were granted
in reliance upon the exemptions from registration pursuant to Section 4(2) of
the Securities Act and reliance on Regulation D, investment representations were
obtained. The options are exercisable upon an effective registration statement
under the Securities Act of 1933 or one year from the date of issuance. The
options expire on January 14, 2003.

On March 6, 1998, the Company, for net proceeds of $1,980,000, issued 2,200
shares of Series 98A 6% Convertible Preferred Stock pursuant to the provisions
of Regulation D to two accredited investors. The 98A Preferred Shares accrue
dividends at a rate of 6% per annum and are cumulative. The dividend is only
payable in common stock of the Company. The Company also issued warrants to
purchase a total of 90,000 common shares at $1.27 per share to these investors.
The Series 98A Preferred Stock is convertible, at the

<PAGE>

earlier of the date the underlying common shares are included
in a registration statement which has been
declared effective by the SEC, or sixty days from the closing date, March 6,
1998. Each Series 98A share is convertible into the number of shares of common
stock derived by dividing the conversion rate by the conversion price. The
conversion rate is the liquidation preference of $1,000 per share of the Series
98A Preferred Stock. The conversion price is determined based on the date the
conversion notice is received and is equal to the lesser of (a) the average
closing bid price of the Common Stock over the five day trading period prior to
the closing date or (b) 75% of the average of the closing bid price of the
common stock on the five trading days ending on the date preceding the
conversion notice. No sale can occur absent an effective registration statement
for the underlying stock. The warrants were exercisable 10 days after issuance
and expire on March 6, 2003. The 98A Preferred Shares are redeemable at the
option of the Company, in whole or in part, in cash, at 130% of the Liquidation
value plus accrued and unpaid dividends. The 98A Preferred Shares will
automatically convert into common stock two years from the closing date. These
securities were issued pursuant to the exemptions provided by Section 4(2) of
the Securities Act and Regulation D. Investment representations were obtained
from the investors and legends were placed on the certificates.

<PAGE>

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data has been derived from the audited
consolidated financial statements of the Company, certain of which appear
elsewhere in this Reports together with the reports of the Company's
Independent Auditors, whose reports include an explanatory paragraph relating
to an uncertainty concerning the Company's ability to continue as a going
concern. The selected financial data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Company's consolidated financial statements and notes
thereto.

<TABLE>

                                                   Years ended December 31,
<S>                           <C>             <C>            <C>             <C>           <C>
---------------------------------------------------------------------------------------------------------
                                   1993           1994           1995           1996           1997
                                   ----           ----           ----           ----           ----
Statement of Operations Data:

Revenue                        $ 809,910      $ 552,503      $ 900,306(1)    $4,244,268    $ 5,322,724

Net loss                      (6,116,388)    (5,844,121)    (6,824,940)(1)   (4,259,365)    (5,708,302)

Imputed Dividends                     --             --             --               --       (770,226)

Net Loss Applicable
  to Common Stock             (6,116,388)    (5,844,121)    (6,824,940)      (4,259,365)    (6,478,528)

Net Loss Per Common Share -
  Basic                            (3.02)         (3.02)         (2.46)(1)        (0.80)         (0.88)

Weighted Average
Shares Outstanding             1,691,675      1,933,032      2,744,084        5,357,010      7,324,953

Balance Sheet Data:

Current Assets               $ 1,331,381      $ 717,406      $ 944,910      $ 2,295,167    $ 1,648,745

Working Capital
Deficiency                      (917,979)    (3,348,255)    (2,369,079)      (4,015,187)    (4,284,559)

Total Assets                   9,240,338      8,198,362      6,592,086        6,628,678      5,590,445

Long-Term Debt
 (Excluding Current
   Portion)                    4,637,997      3,575,835      4,631,250          123,750        114,250

Stockholders'
  Equity (Deficiency)          2,350,981        556,866     (1,629,578)         194,574       (457,109)
---------------------------------------------------------------------------------------------------------

Note: No dividends have been declared since inception.

(1)  The Company acquired AMS effective October 30, 1995. AMS recorded revenue
     of $867,000 and income from operations of $238,000 for the period October
     31, 1995, through December 31, 1995.
</TABLE>

<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

Forward-Looking Statements: This Annual Report on Form 10-K contains statements
relative to: (i) projections, (ii) estimates, (iii) future research plans and
expenditures, (iv) potential collaborative arrangements, (v) opinions of
management, and (vi) the need for and availability of additional financing;
which may be considered forward looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. These forward-looking statements are made pursuant to the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995.

The forward-looking statements included herein are based on current expectations
that involve a number of risks and uncertainties. These forward-looking
statements are based on assumptions regarding the Company's business and
technology, which involve judgments with respect to, among other things, future
scientific, economic and competitive conditions, and future business decisions,
as well as risk factors detailed from time to time in the Company's SEC reports
including this Form 10-K, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking statements
are reasonable, any of the assumptions could prove inaccurate and, therefore,
there can be no assurance that the results contemplated will be realized and
actual results may differ materially. Readers are urged to carefully review and
consider the various disclosures made by the Company in this report and in the
Company's other reports filed with the SEC that attempt to advise interested
parties of the risks and factors that may affect the Company's business.
Therefore, historical results and percentage relationships will not necessarily
be indicative of the operating results of any future period. The Company
undertakes no obligation to publicly update or revise any forward-looking
statements, to reflect new information, events or circumstances, or reflect the
occurrence or non-occurrence of unanticipated events after the date hereof.

Results of Operations

Year ended December 31, 1997, compared to Year ended December 31, 1996.

Sales and Cost of Sales. Sales and cost of sales are primarily attributable to
AMS and are recorded using the percentage of completion method. Net sales for
1997 increased 34% over 1996. The Company attributes the increase in sales to a
change in marketing strategy. AMS is currently focusing its marketing efforts on
the western region of the U.S. with a heightened emphasis on the High-Tech
industry. In 1997, sales to the High-Tech industry increased 225% over the prior
year and sales to the automotive and medical industries declined 19% and 31%
respectively, primarily as a result of the change in marketing strategy.
Consequently, AMS is continuing its current marketing strategy and is
anticipating another strong year in 1998. Cost of sales as a percentage of sales
declined 13%, compared to the prior year, as the 1996 cost of sales amount
contained the results of a job overrun. Management believes that the current
year results are more indicative of future operations at AMS.

Other Income. Other income for 1997 decreased 86% from 1996. The decrease is
related to the forgiveness of certain royalty obligations by a related party
totaling $142,000 and the reversal of estimated tax expenses related to the
acquisition of AMS, totaling approximately $110,000 in the prior year.

Loss on Investment in TEK-KOL. The Company's TEK-KOL loss for the year increased
102% over 1996. This increase is primarily the result of TEK-KOL's efforts to
increase the economic value of CDL and thereby improve the entire economics of
an LFC plant. In addition to the CDL enhancement program costs, TEK-KOL received
certain non-recurring payments of approximately $350,000 under an agreement with
MHI during the prior year.

Engineering Research and Consulting Expenses. The Company's engineering research
and consulting expenses for 1997 increased 91% over 1996. The increase relates
to the Company's heightened efforts to develop the OCET process.

Selling, General and Administrative Expenses. Selling, general and
administrative expense increased 71% over 1996 after adjusting for a 1996
non-recurring non-cash charge of $158,000, related to employee

<PAGE>

warrant exercises with non-recourse notes. AMS's addition of sales personnel
and its increased marketing efforts account for approximately 50% of the
overall increase. The remaining portion of the 1997 increase is related to the
Company's expanded usage of public relations and financial consultants, as well
as a one-time charge of approximately $155,000 related to the write-off of
certain contingent notes receivable.

Legal and Accounting Expenses. The Company's legal and accounting expenses for
the year ended December 31, 1997, decreased 14% from 1996, after adjusting for
non-recurring non-cash charges of $316,000, related to employee warrant
exercises with non-recourse notes. The remaining decrease is due to cost
reduction activities in these areas.

Depreciation and Amortization Expenses. Depreciation and amortization expense
increased 17% over 1996. The increase is due primarily to purchases and
construction of additional equipment at the Company's OCET laboratory.

Interest Expense. Interest expense increased 8% ($43,000) over 1996, after
adjusting for a one-time non-recurring imputed interest charge of $176,000. The
imputed interest charge is related to the issuance of 12% convertible
debentures, with a non-detachable beneficial conversion feature on the date of
issuance. The increase is due primarily to increased borrowing on the line of
credit as compared to the prior year.

Year ended December 31, 1996, compared to Year ended December 31, 1995.

The Company acquired AMS effective October 30, 1995. The acquisition of AMS has
been accounted for as a purchase and, accordingly, the operating results of AMS
have been included in the Company's consolidated financial statements. AMS
recorded revenue and income from operations of $3,939,000 and $498,000,
respectively, during the twelve months ended December 31, 1996. AMS recorded
revenue and income from operations of $867,000 and $238,000, respectively, for
the period subsequent to October 30, 1995. As the Company's 1995 financial
statements only include two months of operations, management does not believe a
comparison to 1996 operations would be meaningful. As such the following
discussions do not include the effect of AMS's operations unless otherwise
stated. (Refer to Note 6 of the consolidated financial statements).

Sales and Cost of Sales. Cost of Sales as a percentage of sales for AMS
increased in from 73% in 1995 to 87% in 1996 as a result of a one time job
overrun in 1996.

Other Income. Other income in 1996 increased 808% over 1995. The increase is
primarily related to the forgiveness of certain royalty obligations by a related
party totaling $142,000 and the reversal of estimated tax expenses related to
the acquisition of AMS, totaling approximately $110,000 in 1996.

Loss on Investment in TEK-KOL. TEK-KOL's activities increased significantly in
1996; therefore, the Company's share of the partnership's 1996 loss increased
61% over 1995.

Research and Development Expenses. Engineering, research and development
expenses in 1996 decreased 58% from 1995. Management curtailed certain
engineering activities and TEK-KOL assumed those responsibilities as well as all
LFC Process marketing activities which contributed to the decrease. Current year
expenses relate primarily to design of the OCET Process.

Selling, General and Administrative Expenses. General and administrative
expenses in 1996 decreased 3% from 1995. The 1996 expenses include non-recurring
charges of $158,000 related to employee warrant exercises with non-recourse
notes. In 1995, the Company allocated general and administrative expense of
$651,000 to engineering, research and development expense based on "LFC"
employee hours worked. No such allocation was made in 1996. After adjusting for
non-recurring charges and expense allocation differences, general and
administrative expense decreased 14% from 1995.

Legal and Accounting Expenses. Legal and accounting expenses in 1996 increased
56% over 1995. The 1996 expenses include non-recurring charges of $316,000
related to employee warrant exercises with non-recourse notes. After adjusting
for the non-recurring charges, legal and accounting expense increased 2%.

<PAGE>

Depreciation and Amortization Expenses. Depreciation and amortization expenses
in 1996 decreased 71% from 1995. Certain LFC process-related assets were written
off in 1995 following management's evaluation of their estimated net carrying
value. Accordingly, depreciation expenses decreased due to the overall decline
in LFC related assets.

Interest Expense. Interest expense of $522,470 is directly related to the amount
of debt outstanding during the period, the stated interest rate and note
discounts amortized. Interest expense decreased 53% in 1996 as all note
discounts had been fully amortized as of December 31, 1995, all as discussed in
Note 5 of the notes to the consolidated financial statements.

Liquidity and Capital Resources

As of December 31, 1997, the Company had assets totaling $5.2 million, including
unrestricted cash of $429,232, and a working capital deficiency of $4.3 million.
The Company anticipates continued operating losses over the next twelve months
and has both short-term and long-term liquidity deficiencies as of December 31,
1997. The Company had short-term liquidity deficiencies at December 31, 1997,
and 1996, of $4.3 million and $4.0 million, respectively. Current notes payable
and associated accrued interest of $4.5 million contribute to the Company's
short-term deficiency at December 31, 1997. Short-term liquidity requirements
are expected to be satisfied from existing cash balances; proceeds from the sale
of equity securities or other collaborative arrangements. Negotiations are
on-going for the public and private placement of equity securities, the proceeds
of which will be used to satisfy the short-term liquidity deficiency. In the
event that the Company is unable to finance operations at the current level,
various administrative activities would be curtailed and certain research and
development efforts would be reduced. The Company will not be able to sustain
operations if it is unsuccessful in securing sufficient financing and/or
generating revenues from operations.

The Company had long-term liquidity deficiencies at December 31, 1997, and 1996.
Over the long-term, the Company will require substantial additional funds to
maintain and expand its research and development activities and ultimately to
commercialize, with or without the assistance of corporate partners, any of its
proposed technologies. The Company believes the long-term liquidity deficiency
will be satisfied through equity sales, increased positive cash flows from AMS's
operations, and research or other collaborative agreements, until such time, if
ever, as the commercialization of the LFC and OCET Processes results in positive
cash flows. The Company is seeking collaborative or other arrangements with
larger well capitalized companies, under which such companies would provide
additional capital to the Company in exchange for exclusive or non exclusive
licenses or other rights to certain technologies and products the Company is
developing. Although the Company is presently engaged in discussions with a
number of suitable candidate companies, there can be no assurance that an
agreement or agreements will arise from these discussions in a timely manner, or
at all, or that revenues that may be generated thereby will offset operating
expenses sufficiently to reduce the Company's short-term or long-term funding
requirements.

The Company's 1997 cash used in operating activities remained approximately the
same as the previous year at $3.2 million. The use of funds from operating
activities is primarily attributable to the Company's financing and
administrative expenses and to OCET's research and development operations.

The Company's investing activities amounted to approximately $1.4 million for
the year ended December 31, 1997. The funds were utilized in the acquisition and
construction of equipment for the OCET laboratory and the funding of the TEK-KOL
Partnership's operations. Additional capital contributions to the TEK-KOL
Partnership are expected to be required from time to time prior to profitable
operations. The Company is required to contribute one-half of any such required
capital contributions. Management estimates that the Company will be required to
contribute between $.75 million and $1.0 million in 1998, if agreements with
existing or other corporate partners are not consummated. The amount of funds
used for investing activities in a given period are directly related to
development requirements and funds availability. The Company does not have
material for capital expenditures as of December 31, 1997.

The Company's financing activities raised approximately $4.3 million for the
year ended December 31, 1997. These funds were raised primarily through the
private placement of equity securities and borrowings on the line-of-credit. The
amount of money raised during a given period is dependent upon financial market

<PAGE>

conditions, technological progress and the Company's projected funding
requirements. The Company anticipates that future financing activities will be
influenced by the aforementioned factors.

The Company had notes payable and associated accrued interest of approximately
$4.8 million due September 30, 1997. In October 1997, the Company was able to
extend, exchange or convert approximately $4.8 million of existing debt for new
securities of the Company including common stock, warrants and revised, amended
or new convertible debt securities. The Company also paid approximately $400,000
on existing notes and interest.

As noted previously, significant future financing activities will be required to
fund future operating and investing activities and to maintain debt service. The
Company is engaged in continuing negotiations to secure additional capital and
financing, and while management believes these negotiations will be successful,
there is no assurance such funding will be available or if received will be
adequate.

Impact of Inflation

The results of the Company's operations for periods discussed have not been
significantly affected by inflation. Further, although AMS often sells products
on a fixed quote basis, the average time between the receipt of an order and
delivery is generally under nine months. Therefore, AMS generally is not
adversely affected by increases in the cost of raw materials and components.
This could change in situations in which AMS is working against a substantial
backlog and may not be able to pass on higher costs to customers. In addition,
interest on the Company's line-of-credit is tied to the prime rate and therefore
may increase with inflation.

Year 2000

The Company recognizes the need to ensure its operations will not be adversely
impacted by Year 2000 software failures. Software failures due to processing
errors potentially arising from calculations using the year 2000 date are a
known risk. The Company has assessed the impact on its computer systems of the
Year 2000 issue. The financial impact of making the required systems changes is
not expected to be material to the Company's consolidated financial position,
results of operations or cash flows.

Recent Accounting Pronouncements

Recent pronouncements of the Financial Accounting Standards Board ("FASB"),
which are not required to be adopted at this date, include Statement of
Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income;" and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information."

In February 1997, the FASB issued SFAS No. 128, "Earnings per Share" which is
required to be adopted on December 31, 1997. SFAS No. 128 replaces Accounting
Principles Board Opinion ("APB") No. 15 and simplifies the computation of
earnings per share ("EPS") by replacing the presentation of primary EPS with a
presentation of basic EPS. Basic EPS includes no dilution and is computed by
dividing income available to common stockholders by the weighted-average number
of common shares outstanding for the period. Diluted EPS reflects the potential
dilution from securities that could share in the earnings of the Company,
similar to fully diluted EPS under APB No. 15. The Statement requires dual
presentation of basic and diluted EPS by entities with complex capital
structures. All per share amounts for all periods presented must be restated to
conform to SFAS No. 128 requirements. The Company has adopted SFAS No. 128 as of
December 31, 1997, however, no restatement of the previously determined per
share amounts is required as the effects of the outstanding convertible
securities, warrants and options would be anti-dilutive.

SFAS No. 130, "Reporting Comprehensive Income" is effective for fiscal years
beginning after December 15, 1997. SFAS No. 130 establishes standards for the
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. The Statement requires that all items that are required to be
recognized under accounting standards as components of comprehensive income be
reported in a financial statement that is displayed with the same prominence as
other financial statements. The Company is evaluating the Statement's provisions
to conclude how it will

<PAGE>

present comprehensive income in its financial statements, and has not yet
determined the amounts to be disclosed. The Company will adopt SFAS No. 130
effective January 1, 1998.

SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information" is effective for financial statements for periods beginning after
December 15, 1997. SFAS No. 131 establishes standards for the way that public
business enterprises report financial and descriptive information about
reportable operating segments in annual financial statements and interim
financial reports issued to stockholders. SFAS No. 131 supersedes SFAS No. 14,
"Financial Reporting for Segments of a Business Enterprise," but retains the
requirement to report information about major customers. The Company is
evaluating the Statement's provisions to determine the additional disclosures
required in its financial statements, if any. The Company will adopt SFAS No.
131 for the fiscal year ended December 31, 1998.

<PAGE>

ITEM 8. FINANCIAL STATEMENTS


Index to Consolidated Financial Statements


Reports of Independent Auditors...........................................22-23

Consolidated Balance Sheets - December 31, 1997, and 1996.................24-25

Consolidated Statements of Operations for the years ended
  December 31, 1997, 1996, and 1995..........................................26

Consolidated Statements of Stockholders' Equity for the
  years ended December 31, 1997, 1996, and 1995..............................27

Consolidated Statements of Cash Flows for the years ended
  December 31, 1997, 1996, and 1995..........................................28

Notes to Consolidated Financial Statements................................29-47

<PAGE>

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Stockholders
SGI International


We have audited the accompanying consolidated balance sheet of SGI International
and subsidiaries as of December 31, 1997, and the related consolidated
statements of operations, stockholders' equity (deficiency), and cash flows for
the year then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.

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

In our opinion, the 1997 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SGI
International and subsidiaries at December 31, 1997, and their results of
operations and cash flows for the year then ended, in conformity with generally
accepted accounting principles.

As discussed in Note 2 to the consolidated financial statements, the Company's
principal assets are related to the LFC (Liquid From Coal) Process. The recovery
of these assets is dependent upon future events, including the Company's ability
to attract sufficient additional equity and/or financing needed to fund its
portion of the TEK-KOL Partnership that is responsible for completion and
commercialization of the LFC Process. These factors and the Company's working
capital deficiency and recurring losses from operations, among others, raise
substantial doubt about its ability to continue as a going concern. Management's
plans in regard to these matters are also discussed in Note 2 to the
consolidated financial statements. The accompanying 1997 consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of reported asset amounts or the amounts and classification of
liabilities that might result from the outcome of this uncertainty.



J. H. COHN LLP


San Diego, California
March 27, 1998


<PAGE>

               Report of Ernst & Young LLP, Independent Auditors


The Board of Directors and Shareholders
SGI International

We have audited the accompanying consolidated balance sheet of SGI International
as of December 31, 1996, and the related consolidated statements of operations,
stockholders' equity (deficiency) and cash flows for each of the two years in
the period ended December 31, 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of SGI International
at December 31, 1996, and the consolidated results of its operations and its
cash flows for each of the two years in the period ended December 31, 1996, in
conformity with generally accepted accounting principles.

As discussed in Note 2 of the notes to consolidated financial statements, the
Company's principal assets are related to the LFC (Liquids From Coal) Process.
The recovery of these assets is dependent upon future events, including the
Company's ability to attract sufficient additional equity and/or financing
needed to fund its portion of the TEK-KOL Partnership, that is responsible for
completion and commercialization of the LFC Process. These factors and the
Company's working capital deficiency and recurring losses from operations at
December 31, 1996, raise substantial doubt about its ability to continue as a
going concern. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

ERNST & YOUNG LLP


San Diego, California
March 20, 1997

<PAGE>
<TABLE>

                       SGI International and Subsidiaries
                          Consolidated Balance Sheets

                                                                               December 31,
                                                                      --------------------------
                                      Assets                               1997         1996
                                                                      --------------------------
<S>                                                                   <C>            <C>
Current assets:
  Cash                                                                $  429,232     $ 740,018
  Restricted time deposit                                                402,500       402,500
  Receivable from TEK-KOL Partnership                                     26,066        24,431
  Trade accounts receivable, less allowance for doubtful accounts
   of $84,460 and $7,796                                                 346,763       888,254
  Costs and estimated earnings in excess of billings on contracts        146,364       113,130
  Inventories                                                             64,843        68,289
  Prepaid expenses and other current assets                              232,977        58,545
                                                                      --------------------------
Total current assets                                                   1,648,745     2,295,167
                                                                      --------------------------


LFC Process related assets:
  Notes receivable, net                                                  150,000       304,903
  Royalty rights, net                                                  1,571,250     1,885,500
  LFC cogeneration project, net                                          421,137       526,421
  Investment in TEK-KOL Partnership                                      481,685       464,163
  Australia LFC project, net                                             115,836       144,795
  Other technological assets, net                                         29,598        27,742
                                                                      --------------------------
                                                                       2,769,506     3,353,524

Property and equipment, net of accumulated depreciation and
  amortization of $589,789 and $345,995                                  788,740       548,601
Goodwill, net of accumulated amortization of $96,790 and $48,858         383,454       431,386
                                                                      --------------------------
                                                                      $5,590,445    $6,628,678
                                                                      ==========================
See notes to consolidated financial statements.
</TABLE>

<PAGE>

                       SGI International and Subsidiaries
                          Consolidated Balance Sheets
<TABLE>

                                                                                       December 31,
                                                                             ----------------------------
                                                                                  1997             1996
                                                                             ----------------------------

               Liabilities and Stockholders' Equity (Deficiency)
<S>                                                                           <C>              <C>
Current liabilities:
  Accounts payable                                                            $  287,458       $ 444,436
  Borrowings on line-of-credit                                                   400,000         300,000
  Billings in excess of costs and estimated earnings on contracts                193,792         387,892
  Current maturities of long-term notes payable                                3,061,875       4,216,500
  12% convertible debentures                                                     976,573               -
  Accrued salaries, benefits and related taxes                                   240,368         124,942
  Payable to TEK-KOL Partnership                                                 100,000          83,252
  Interest payable                                                               483,930         529,183
  Other accrued expenses                                                         189,308         224,149
                                                                             ----------------------------
Total current liabilities                                                      5,933,304       6,310,354

Long-term notes payable, less current maturities                                 114,250         123,750

                                                                             ----------------------------
Total liabilities                                                              6,047,554       6,434,104
                                                                             ----------------------------

Commitments and Contingencies

Stockholders' equity (deficiency):
Convertible preferred stock, $.01 par value; 20,000,000 shares authorized,
   90,997 and 88,732 shares issued and outstanding                                   910             887
Common stock, no par value; 75,000,000 shares authorized,
   9,258,250 and 6,094,605 shares issued and outstanding                      39,927,760      36,118,231
  Paid-in capital                                                              8,511,878       6,494,585
  Accumulated deficit                                                        (48,897,657)    (42,419,129)
                                                                             ----------------------------
Total stockholders' equity (deficiency)                                         (457,109)        194,574
                                                                             ----------------------------
                                                                             $ 5,590,445     $ 6,628,678
                                                                             ============================

See notes to consolidated financial statements.

</TABLE>

<PAGE>

                       SGI International and Subsidiaries
                     Consolidated Statements of Operations
<TABLE>

                                                                Years ended December 31,
                                                       --------------------------------------------
                                                            1997           1996           1995
                                                       --------------------------------------------
<S>                                                    <C>            <C>             <C>
Revenues:
  Net sales                                            $ 5,279,589    $  3,938,854    $   866,676
  Other                                                     43,135         305,414         33,630
                                                       --------------------------------------------
                                                         5,322,724       4,244,268        900,306
Expenses:                                              --------------------------------------------
  Cost of sales                                          3,898,737       3,440,381        628,506
  Engineering, research and consulting                   1,267,195         664,887      1,599,826
  Loss on investment in TEK-KOL Partnership                932,477         462,613        288,000
  Selling, general and administrative                    2,952,489       1,880,655      1,377,172
  Legal and accounting                                     504,325         905,466        579,630
  Depreciation and amortization                            734,027         627,161      2,142,957
  Interest                                                 741,776         522,470      1,109,155
                                                       --------------------------------------------
                                                        11,031,026       8,503,633      7,725,246
                                                       --------------------------------------------
Net loss                                                (5,708,302)     (4,259,365)    (6,824,940)

Imputed preferred stock dividends for Series 97B 8%,
  97D 7%, and 97F 8% convertible preferred stock           770,226               -              -
                                                       --------------------------------------------

Net loss applicable to common stock                    $(6,478,528)    $(4,259,365)   $(6,824,940)
                                                       ============================================
Net loss per common share - Basic                      $      (.88)    $      (.80)   $     (2.46)
                                                       ============================================

Weighted average common shares outstanding               7,324,953       5,357,010      2,774,084
                                                       ============================================

See notes to consolidated financial statements.
</TABLE>

<PAGE>

                       SGI International and Subsidiaries
           Consolidated Statements of Stockholders' Equity (Deficiency)
<TABLE>


                                                                           Convertible
                                                                           preferred stock      Common stock
                                                                         ------------------    --------------
                                                                         Shares    Amount    Shares      Amount
                                                                         ---------------------------------------------
<S>                                                                       <C>     <C>        <C>        <C>
Balances at December 31, 1994                                             107,101 $ 1,071    2,104,447  $ 29,377,998
  Issuance of common stock for services and interest                            -       -      389,103       482,166
  Issuance of common stock at $.48 to $10 per share for cash net                -       -      963,035     1,023,956
  Exercise of warrants to purchase common stock for cash and notes              -       -      274,829       318,548
  Issuance of convertible preferred stock for cash, net                   125,002   1,250            -             -
  Conversion of preferred stock                                          (128,533) (1,286)     128,257     1,052,689
  Issuance of convertible preferred stock for notes payable and interest      156       2            -             -
  Issuance of convertible preferred stock to acquire AMS, Inc.                  3       -            -             -
  Net loss                                                                      -       -            -             -
                                                                           -------------------------------------------
Balances at December 31, 1995                                             103,729   1,037    3,859,671    32,255,357
  Issuance of common stock for notes payable, services and interest             -       -      587,278       750,799
  Issuance of common stock at $0.48 to $3.30 per share for cash, net            -       -    1,377,306     2,593,844
  Exercise of warrants to purchase common stock for
   cash and notes payable                                                       -       -      243,528       270,509
  Issuance of convertible preferred stock for notes payable and interest      105       1            -             -
  Conversion of preferred stock                                           (15,101)   (151)      26,822       247,722
  Repurchase of preferred stock                                                (1)      -            -             -
  Warrants granted for notes payable, accounts payable and interest             -       -            -             -
  Compensation expense for warrants exercised with notes receivable             -       -            -             -
  Collection of notes receivable                                                -       -            -             -
Net loss                                                                        -       -            -             -
----------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996                                              88,732     887    6,094,605    36,118,231
  Issuance of common stock for services and interest                            -       -      281,027       384,401
  Issuance of common stock at $1.88 to $4.52 per share for cash, net            -       -      578,042     1,146,081
  Exercise of warrants to purchase common stock for cash                        -       -      150,000       141,385
  Imputed interest on issuance of 12% convertible debenture                     -       -            -             -
  Issuance of convertible preferred stock for cash and notes payable        3,406      34            -             -
  Conversion of preferred stock                                            (1,141)    (11)   2,154,576     2,137,662
  Issuance of warrants to purchase common stock to non-employees                -       -            -             -
Net loss                                                                        -       -            -             -
Preferred Series 97B 8%, 97D 7%, and 97F 8% imputed dividends                   -       -            -             -
----------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1997                                              90,997   $ 910    9,258,250  $ 39,927,760

======================================================================================================================

</TABLE>
<TABLE>

                                                                                                                 Total
                                                                         Paid-in      Accumulated      Notes     stockholders'
                                                                         capital      deficit        receivable  equity (deficiency)
                                                                      --------------------------------------------------------------
<S>                                                                       <C>             <C>               <C>         <C>
Balances at December 31, 1994                                             $ 2,512,621    $(31,334,824)      $     -     $ 556,866
  Issuance of common stock for services and interest                                -               -             -       482,166
  Issuance of common stock at $.48 to $10 per share for cash net                    -               -             -     1,023,956
  Exercise of warrants to purchase common stock for cash and notes                  -               -      (308,423)       10,125
  Issuance of convertible preferred stock for cash, net                     1,112,726               -             -     1,113,976
  Conversion of preferred stock                                            (1,051,403)              -             -             -
  Issuance of convertible preferred stock for notes payable and interest    1,678,492               -             -     1,678,494
  Issuance of convertible preferred stock to acquire AMS, Inc.                329,779               -             -       329,779
  Net loss                                                                          -      (6,824,940)            -    (6,824,940)
------------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1995                                               4,582,215     (38,159,764)     (308,423)   (1,629,578)
  Issuance of common stock for notes payable, services and interest                 -               -             -       750,799
  Issuance of common stock at $0.48 to $3.30 per share for cash, net                -               -             -     2,593,844
  Exercise of warrants to purchase common stock for cash and notes payable          -               -             -       270,509
  Issuance of convertible preferred stock for notes payable and interest    1,583,396               -             -     1,583,397
  Conversion of preferred stock                                              (245,511)              -             -         2,060
  Repurchase of preferred stock                                               (41,223)              -             -       (41,223)
  Warrants granted for notes payable, accounts payable and interest           141,603               -             -       141,603
  Compensation expense for warrants exercised with notes receivable           474,105               -             -       474,105
  Collection of notes receivable                                                    -               -       308,423       308,423
Net loss                                                                            -      (4,259,365)            -    (4,259,365)
------------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 1996                                               6,494,585     (42,419,129)            -       194,574
  Issuance of common stock for services and interest                                -               -             -       384,401
  Issuance of common stock at $1.88 to $4.52 per share for cash, net                -               -             -     1,146,081
  Exercise of warrants to purchase common stock for cash                            -               -             -       141,385
  Imputed interest on issuance of 12% convertible debenture                   175,922               -             -       175,922
  Issuance of convertible preferred stock for cash and notes payable        3,000,733               -             -     3,000,767
  Conversion of preferred stock                                            (2,137,651)              -             -             -
  Issuance of warrants to purchase common stock to non-employees              208,063               -             -       208,063
Net loss                                                                            -      (5,708,302)            -    (5,708,302)
------------------------------------------------------------------------------------------------------------------------------------
Preferred Series 97B 8%, 97D 7%, and 97F 8% imputed dividends                 770,226        (770,226)            -             -
Balances at December 31, 1997                                             $ 8,511,878   $ (48,897,657)          $ -    $ (457,109)
====================================================================================================================================

See notes to consolidated financial statements.

</TABLE>

<PAGE>



                       SGI International and Subsidiaries
                     Consolidated Statements of Cash Flows
<TABLE>

                                                                    Years ended December 31,
                                                           ------------- ------------- ---------------
                                                               1997           1996          1995
                                                           ------------- ------------- ---------------
<S>                                                        <C>           <C>           <C>
Operating activities:
Net loss                                                    (5,708,302)   (4,259,365)      (6,824,940)
Adjustments to reconcile net loss
  to net cash used in operating activities:
Depreciation and amortization                                  734,027       659,660        1,164,157
 Write-down and write-off of LFC related assets                154,903             -          978,800
 Write-off of receivables from officers and directors                -             -          396,961
 Amortization of note discounts                                      -             -          269,064
 Common stock and warrants issued for services
   and interest                                                279,251       211,650          603,160
 Imputed interest on 12% convertible debenture                 175,922             -                -
 Non-employee compensation expense on issuance
   of warrants                                                 208,063             -                -
 Compensation for warrants exercised with notes
   receivable                                                        -       474,105                -
 Equity in net loss of TEK-KOL Partnership                     932,477       462,613          288,000
 Forgiveness of royalty payable to officer/stockholder               -      (141,790)         (88,064)
 Changes in operating assets and liabilities:
   Receivable from TEK-KOL Partnership                          (1,635)       51,093          (29,701)
   Trade accounts receivable                                   508,257      (388,584)         (59,162)
   Inventories                                                   3,446             -              500
   Prepaid expenses and other current assets                   (87,193)      102,248            5,266
   Accounts payable                                           (156,978)     (239,147)         (65,664)
   Billings in excess of costs and estimated earnings
    on contracts                                              (194,100)      212,147           77,188
   Accrued salaries, benefits and related taxes                115,426      (154,161)          54,473
   Interest payable                                              5,231       113,095          247,044
   Other accrued expenses                                      (34,840)     (154,420)          20,849
                                                           ------------- ------------- ---------------
Net cash used in operating activities                       (3,066,045)   (3,050,856)      (2,962,069)
                                                           ------------- ------------- ---------------
Investing activities:
Cash acquired from AMS                                               -             -           21,184
Purchase time deposit                                                -      (402,500)               -
LFC process related assets:
  Collection of notes receivable and related interest, net           -     1,717,258          117,235
  Additions to other technological assets                      (10,129)       (1,302)         (33,183)
  Additions to process demonstration equipment                       -             -          (31,511)
  Investment in TEK-KOL Partnership                           (950,000)     (330,500)        (472,000)
Payable to TEK-KOL Partnership                                  16,749      (228,748)         412,000
Purchase of property and equipment                            (469,469)     (408,727)         (45,469)
Other assets                                                         -        12,876           63,274
                                                           ------------- ------------- ---------------
Net cash provided by (used in) investing
  activities                                                (1,412,849)      358,357           31,530
                                                           ------------- ------------- ---------------
Financing activities:
Borrowings on line-of-credit                                   100,000       300,000                -
Proceeds from issuance of notes payable                              -        50,000          830,362
Payment of notes payable                                      (210,125)     (125,250)        (525,025)
Proceeds from issuance of convertible preferred
  stock and warrants, net                                    2,990,767             -        1,113,976
Redemption of preferred stock                                        -       (41,223)               -
Proceeds from issuance of common stock                       1,287,466     3,174,836        1,034,081
                                                           ------------- ------------- ---------------
Net cash provided by financing activities                    4,168,108     3,358,363        2,453,394
                                                           ------------- ------------- ---------------
Net increase (decrease) in cash                               (310,786)      665,864         (477,145)

Cash at beginning of the year                                  740,018        74,154          551,299
                                                           ============= ============= ===============
Cash at the end of the year                                  $ 429,232     $ 740,018        $  74,154
                                                           ============= ============= ===============

Supplemental disclosure of cash flow information:
Cash paid for interest                                       $ 411,000     $ 195,000        $ 294,000
                                                           ============= ============= ===============
Supplemental disclosure of non-cash activities:

Series 97 convertible preferred stock issued
  for notes payable and interest                            $   13,000             -                -
                                                           ============= ============= ===============
Convertible debentures and common stock issued
  for notes payable and interest                            $  977,000             -                -
                                                           ============= ============= ===============
Common stock and warrants issued for current
  liabilities                                               $  116,000             -                -
                                                           ============= ============= ===============
Series 96 convertible preferred stock issued
for notes payable and interest                                       -     $1,583,000              -
                                                           ============= ============= ===============
Series 95 convertible preferred stock issued
to acquire AMS                                                       -              -         330,000
                                                           ============= ============= ===============
Series 95 convertible preferred stock issued
for notes payable                                                    -              -       1,557,500
                                                           ============= ============= ===============
Warrants exercised in exchange for notes
payable                                                              -        230,000         308,000
                                                           ============= ============= ===============
Common stock or warrants issued for notes
  payable, services and interest                               384,000        751,000         482,000
                                                           ============= ============= ===============
Conversion of preferred stock                              $ 2,138,000      $ 246,000     $ 1,053,000
                                                           ============= ============= ===============
See notes to consolidated financial statements.

</TABLE>

<PAGE>


                       SGI International and Subsidiaries
                   Notes to Consolidated Financial Statements


1. Business, Organization and Principles of Consolidation

SGI International (the "Company") was organized in 1985 as the successor to
certain other businesses. Through 1994, the principal business of the Company
was to license the Liquids From Coal ("LFC") Process technology as exclusive
licensing agent for the TEK-KOL Partnership (TEK-KOL's formation is discussed in
Note 4), to provide expert technical services to all LFC Process related
activities and projects and to develop Clean Coal Refineries worldwide. During
1995, the Company commenced development of the OCET (Opti-Crude Enhancement
Technology) Process which is designed to increase the amount of high quality
fuels refined from residual oil, and the Company acquired a manufacturing
business that fabricates and sells automated assembly equipment. Since
inception, the Company has financed its research and development of the LFC and
OCET processes by private placement of debt and equity securities and to a
lesser extent through research and development contracts.

The Company has the following wholly-owned subsidiaries at December 31, 1997:
Assembly & Manufacturing Systems, Inc. ("AMS"); OCET Corporation ("OCET"); and
U.S. Clean Coal Refineries, Inc. ("USCCR"). AMS designs, manufactures and
installs automated assembly equipment, and was acquired in October 1995 (Note
6). OCET was organized in February 1995 to research and develop the Opti-Crude
Enhancement Technology, a process for further refining residual oil bottoms.
USCCR was organized in October 1994 to market clean coal refinery project
development programs.

SGI Australia Pty. Ltd. ("SGIA") was organized in 1985 and became a wholly-
owned subsidiary in 1993. SGIA was established to commercialize the LFC Process
technology in Australia and New Zealand. During 1997, the Company dissolved
SGIA as it was determined that a special purpose subsidiary was no
longer required to effectively market the LFC Process in Australia.

The consolidated financial statements include the accounts of the Company and
its subsidiaries. All significant intercompany transactions have been eliminated
in consolidation.


2. Significant Accounting Policies

Basis of Presentation. The accompanying consolidated financial statements are
prepared on a going concern basis. The recovery of amounts invested in the
Company's principal assets, the LFC Process related assets, is dependent upon
the Company's ability to adequately fund its capital contributions to TEK-KOL
and TEK-KOL's ability to successfully attract sufficient additional equity, debt
or other third-party financing to complete the commercialization of the LFC
Process technology.

Success in commercialization of the LFC Process is dependent in large part upon
the ability to enter into satisfactory arrangements with other partners,
financiers or customers and upon the ability of these third parties to perform
their responsibilities. The resources required to profitably develop, construct
and operate an LFC plant are likely to include hundreds of millions of dollars,
and expertise in major plant development and operations. There can be no
assurance any licenses, joint venture agreements or other arrangements will be
available on acceptable terms, if at all; that any revenue will be derived from
such arrangements; or that, if revenue is generated, any of said arrangements
will be profitable to TEK-KOL or the Company. If the Company and TEK-KOL are
unsuccessful in their attempts to license the LFC Process, or if such third
parties are unsuccessful in profitably developing and operating LFC plants, the
planned business and operations of the Company will likely not succeed and the
Company would not be able to recover the carrying value of the long-lived assets
related to LFC Process.

The Company had negative working capital of $4.3 million and an accumulated
deficit of $48.9 million at December 31, 1997. These factors and the Company's
recurring losses from continuing operations, among others, raise substantial
doubt about the Company's ability to continue as a going concern. The Company is
currently seeking additional financing through public or private sales of its
securities to fund working capital requirements.

<PAGE>

                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


2. Significant Accounting Policies (continued)

The Company will also seek funding through additional strategic partnerships,
joint ventures or similar arrangements to commercialize the technologies. There
can be no assurance that any collaborative financing arrangements through a
joint venture, and/or with strategic partners, will be available when needed, or
on terms acceptable to the Company. If adequate funds are not available, the
Company may be required to curtail or terminate one or more of its operating
activities. The Company is engaged in continuing negotiation to secure
additional capital and financing, and while management believes funds can be
raised, there is no assurance that their efforts will be successful. The
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.

Estimates and Assumptions. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and disclosures made in the accompanying notes to the consolidated
financial statements. Actual results could differ from those estimates.

Concentration of Credit Risk. The Company invests its excess cash in interest
bearing deposits with major banks, commercial paper and money market funds.
Although certain of the cash accounts may exceed the federally insured deposit
amount, management does not anticipate non-performance by the other parties.
Management reviews the stability of these institutions on a periodic basis.

Inventories. Inventories are stated at the lower of cost or market. The Company
uses the first-in, first-out method of determining cost.

Accounting for Long-Lived Assets. Effective January 1, 1996, the Company adopted
FASB Statement No. 121, "Accounting for Long-Lived Assets and Long-Lived Assets
to Be Disposed Of." The Company records impairment losses on long-lived assets
used in operations when events and circumstances indicate that assets might be
impaired and the undiscounted cash flow estimated to be generated by those
assets are less than the carrying amounts of those assets. The LFC Process
related assets and other long-lived assets are evaluated continually by
management for evidence of impairment. In performing its evaluation, management
considers such factors as competing technologies, current and future market
potential for products generated from the LFC Process technology, viability of
projects or assets and progress of related projects such as the Colstrip Project
and the TEK-KOL Partnership. The Company's estimate of undiscounted cash flows
indicated that such carrying amounts were expected to be recovered. This
analysis is based upon the successful development, construction and operation of
a commercial LFC plant as discussed in the second paragraph of this Note. It is
reasonably possible that the estimate of undiscounted cash flows may change in
the near term resulting in the need to write-down the LFC Process related assets
to fair value.

Depreciation and Amortization. Royalty rights, the LFC cogeneration project and
the Australian LFC project are stated at cost and are being amortized over ten
years. Process demonstration equipment is stated at cost and is being
depreciated over five years. Property and equipment is stated at cost and is
being amortized over three to five years. Goodwill related to the AMS
acquisition is being amortized over ten years. Depreciation and amortization on
the LFC Process related assets and other long-lived assets is calculated using
the straight-line method and the depreciation and amortization periods are based
on management's estimates of the useful lives of the respective assets.

Revenue Recognition. Revenues from engineering and consulting services are
recorded as the services are performed and earned in accordance with the
contracts to perform such services. Revenues from manufacturing contracts are
recorded using the percentage-of-completion method of accounting, based upon the
ratio of costs incurred to total estimated costs. Estimated losses are recorded
in their entirety when loss contracts are identified. Contracts may extend over
one or more accounting periods, and revisions in estimated costs and revenue
recognition during the course of the work are reflected during the accounting
period in which the facts that require such revisions become known. Other income
consists primarily of interest income and is recorded as earned.

<PAGE>
                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


2. Significant Accounting Policies (continued)

Stock Based Compensation Awards. Management recommends and the Board of
Directors authorizes warrant grants to employees and other individuals on a
periodic basis. Warrant grants are not made pursuant to a qualified plan;
therefore, all warrants issued have a non-qualified tax status.

In accordance with the provisions of Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Company has
elected to follow Accounting Principles Board Opinion No. 25 "Accounting for
Stock Issued to Employees" ("APB 25") and related interpretations in accounting
for stock based compensation awards to employees. Under APB 25, if the exercise
price of the Company's warrants equals or exceeds the fair value of the
underlying stock on the grant date, no compensation expense is recorded. Stock
based compensation awards issued to non-employees are accounted for in
accordance with SFAS 123. See Note 7 for pro forma disclosures required by SFAS
123.

Common Shares Issued for Services. The values assigned to the restricted common
shares issued for services are recorded at the estimated fair value of the
services rendered or the value of the restricted common shares issued, which
ever is more readily determinable.

Income Taxes. Income taxes are provided for in accordance with the provisions of
SFAS No. 109. Under this method, the Company recognizes deferred tax assets and
liabilities for the expected future tax effects of temporary differences between
the carrying amounts of assets and liabilities used for financial reporting and
income tax purposes, as well as operating loss carryforwards.

Net Loss per Share. Net loss per share is computed based on the weighted average
number of common shares outstanding and includes preferred stock dividends.
Shares issuable upon conversion of preferred stock, convertible debentures and
upon exercise of outstanding stock options and warrants are not included since
the effects would be anti-dilutive. For purposes of computing net loss per
share, preferred stock dividends include "imputed dividends" for preferred stock
issued with a non-detachable beneficial conversion feature near the date of
issuance. Imputed dividends represent the aggregate difference between
conversion price and the fair market value of the common stock as of the date of
issuance of the preferred stock, without regard to the actual date on which the
preferred stock may be converted.

In February 1997, the FASB issued SFAS No. 128, "Earnings per Share" which is
required to be adopted on December 31, 1997. SFAS No. 128 replaces Accounting
Principles Board Opinion ("APB") No. 15 and simplifies the computation of
earnings per share ("EPS") by replacing the presentation of primary EPS with a
presentation of basic EPS. Basic EPS includes no dilution and is computed by
dividing income available to common stockholders by the weighted-average number
of common shares outstanding for the period. Diluted EPS reflects the potential
dilution from securities that could share in the earnings of the Company,
similar to fully diluted EPS under APB No. 15. The Statement requires dual
presentation of basic and diluted EPS by entities with complex capital
structures. All per share amounts for all periods presented must be restated to
conform to SFAS No. 128 requirements. The Company has adopted SFAS No. 128 as of
December 31, 1997, however, no restatement of the previously determined per
share amounts is necessary as the effects of the outstanding convertible
securities, warrants and options would be anti-dilutive.

Reclassification. Certain prior year amounts have been reclassified to conform
to the fiscal 1997 presentation. These changes had no impact on previously
reported results of operations, cash flows or stockholder's equity.


3. Composition of Certain Financial Statement Captions

Billings

As of December 31, 1997, billings on contracts in progress of $2,404,000
exceeded costs incurred and estimated earnings on contracts of $2,357,000 by
$47,000. As of December 31, 1996, billings on contracts in progress of
<PAGE>

                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


3. Composition of Certain Financial Statement Captions (continued)

$5,366,000 exceeded costs incurred and estimated earnings on contracts of
$5,091,000 by $275,000. The amounts are included in the accompanying
consolidated balance sheets under the following captions:

<TABLE>

                                                       December 31,
                                            -----------------------------------
                                                  1997            1996
                                            -----------------------------------
<S>                                            <C>              <C>
Costs and estimated earnings in excess
  of billings on contracts                     $ 146,364        $ 113,130
Billings in excess of costs and estimated
  earnings on contracts                         (193,792)        (387,892)
                                            ===================================
                                               $ (47,428)      $ (274,762)
                                            ===================================
</TABLE>
<TABLE>

Property and Equipment

                                                       December 31,
                                           ------------------------------------
                                                  1997            1996
                                           ------------------------------------
<S>                                            <C>             <C>
Office furniture and fixtures                  $ 109,000       $ 117,000
Laboratory equipment                             836,000         447,000
Machinery and equipment                          118,000          63,000
Computer equipment                               295,000         262,000
Leasehold improvements                            21,000           6,000
                                           ------------------------------------
                                               1,379,000         895,000
Less accumulated depreciation                   (590,000)       (346,000)
                                           ====================================
Net property and equipment                     $ 789,000       $ 549,000
                                           ====================================

</TABLE>

4. LFC Process Related Assets

Notes receivable In June 1985, Montana One Partners ("MOP"), a California
limited partnership, was formed to develop an LFC-CoGen Plant in Colstrip,
Montana (the "Colstrip Project"). The Company was the sole general partner.
Originally, the limited partners purchased a 5.93% preferred interest in MOP for
$1,462,000; 84.07% was acquired by the Company and 10% by an affiliate, AEM
Corp.

Pursuant to agreements executed in 1988 (the Colstrip Sale Agreements), MOP sold
its interest in the Colstrip Project and the Company sold its interest in
certain other projects to four individuals who formed Rosebud Energy Corp.
("Rosebud"). The sales price of $6,769,000 included $3,500,000 of 8% notes
payable, liabilities aggregating $2,519,000 which were assumed by Rosebud and
liabilities of $750,000 which were forgiven. The basis of the assets sold was
$5,317,000. The Company recognized the immediate reduction of accounts payable
and deferred the remaining gain of $702,000. The notes were non-recourse, and
collectibility was contingent on profitable operations or future financing of
the Colstrip Project.

The transaction was recorded as a non monetary exchange, and because of the
contingencies on the note payments, no gain or interest income will be
recognized until the proceeds received are in excess of the basis of assets
sold.

By December 31, 1991, the Company had acquired the limited partners' 5.93%
preferred interest and AEM's 10% interest in MOP in exchange for cash
($727,000), contingent notes payable ($1,124,500) and warrants to purchase
28,688 common shares at $10 per share. The notes payable to MOP former limited
partners ("FLP") and AEM are payable only out of the Company's collections on
the contingent notes received from Rosebud.

As of December 31, 1995, the Company had received principal payments of
$375,000, interest payments of $739,000 and had written off notes receivable
with a face value of $425,000.

<PAGE>

                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


4. LFC Process Related Assets (continued)

During August through October 1996, the Company entered into the following
agreements with the certain FLPs and the Rosebud individuals. The Company
offered to exchange a preferred share convertible into 3,000 restricted common
shares and a warrant to purchase 3,000 restricted common shares at $5.75 per
share for each FLP's contingent note payable. Approximately 76% of the FLPs
accepted this offer, and the Company issued 35 Series 96B preferred shares
convertible into 105,000 restricted common shares and warrants to purchase
105,000 restricted common shares at $5.75 per share. The Rosebud individuals
paid the Company $1,525,000 in exchange for the notes held by the Company from
the 1988 Colstrip Project sale and the related accrued interest. The Company
combined these transactions for reporting purposes and recorded $788,000 as the
valuation of the securities issued to the FLPs.

On December 11, 1997, the Company finalized an agreement with AEM, whereby the
Company issued 25,714 shares of restricted common stock and two warrants to
acquire an aggregate of 37,714 of common shares at $5.75 per share, in exchange
for current obligations to AEM of approximately $116,000. In addition, the
Company acquired all of AEM's interest in future collections on the contingent
notes receivable, as well as a 12% distributed net profits interest in a
potential LFC cogeneration facility.

The remaining balances of notes receivable and related accounts represent
amounts due from the 1988 sale of certain other projects and contingent amounts
payable to the remaining FLPs. During 1997 the Company wrote-off as
uncollectible, notes receivable of $150,000 and $170,000 of related interest.
The components of the net carrying value of the notes receivable on the
accompanying consolidated balance sheets are as follows:
<TABLE>

                                                          December 31,
                                            -----------------------------------
                                                   1997               1996
                                            -----------------------------------
<S>                                             <C>                <C>
8% notes receivable                             $ 150,000          $ 300,000
Interest receivable                               166,265            288,203
                                            -----------------------------------
                                                  316,265            588,203
                                            -----------------------------------

Deferred gain and interest income                (141,631)           202,193)
8% notes contingently payable to
   FLP's and AEM                                  (24,634)           (81,107)
                                            -----------------------------------
Net carrying value                              $ 150,000          $ 304,903
                                            ===================================
</TABLE>

Royalty Rights. LFC Technology Partners ("LFCTP") originally financed research
and development of the LFC Process technology under certain research agreements
entered into with the Company from 1982 to 1986. As provided under the research
agreements, LFCTP provided cash and issued notes to the Company in exchange for
all rights in the LFC Process technology. On October 1, 1987, the Company and
LFCTP entered into an Amended Technology Transfer Agreement (the transfer
agreement), which provided for the transfer of all rights in the LFC Process
technology to the Company in exchange for three levels of royalty payments. The
first level of royalty payments was satisfied during 1992.

In 1992, the Company and LFCTP entered into a Settlement Agreement which
provided for modifications of the second and third level royalty payments. In
exchange for 12,500 shares of Series 92-C convertible preferred stock, LFCTP's
third level royalty under the transfer agreement was reduced from 12.5% of the
Company's future net cash receipts (as defined) to zero and LFCTP's second level
royalty under the transfer agreement was reduced from approximately $9 million
at December 1992 to $10,000 per month plus 25% of net cash receipts generated by
the Colstrip Project.

Royalty rights aggregating $3,142,500 were recorded in 1992 based upon the value
of the underlying common shares. Royalty expense will be recognized as would
have been required under the transfer agreement or evenly over 10 years,
whichever is greater. Amortization expense of $314,250 was recorded during 1997,
1996, and 1995, and accumulated amortization totals $1,571,250 and $1,257,000 at
December 31, 1997, and 1996, respectively.


<PAGE>
                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


4. LFC Process Related Assets (continued)

LFC Cogeneration Project. The Company has substantially completed the design
and engineering of an LFC facility for use in conjunction with an electric
cogeneration plant. Amounts capitalized at December 31, 1997, relate primarily
to plans and drawings for the design of such a facility. Amortization expense of
$105,000 was recorded during 1997, 1996, and 1995, and accumulated amortization
totaled $631,000 and $526,000 at December 31, 1997, and 1996, respectively.

Pursuant to the Colstrip Sale Agreements, the Company granted Rosebud a
non-exclusive license for LFC Process cogeneration plants with an aggregate
capacity of 350 megawatts which provides for the Company to receive royalties of
up to $1,000,000 from future plant financings and operations.

Investment in TEK-KOL Partnership. The Company entered into a Technology
Purchase Agreement (the "Agreement") with Shell Mining Company ("SMC") on
September 28, 1989. Under the Agreement, SMC acquired a one-half interest in
the LFC Process technology, related stand-alone assets and patents in exchange
for $650,000 in cash, a $550,000 note, and forgiveness of $350,000 of current
debt. SMC also agreed to pay additional consideration totaling $1,000,000 when
the first LFC plant became operational or $40,000 per month, up to an aggregate
of $1,000,000 beginning July 1992. Because of the time period involved over
which the proceeds were collected, the Company recognized the revenue as the
consideration was received.

The Company and SMC formed TEK-KOL on September 30, 1989, and each partner
contributed its respective one-half interest in the LFC Process, related LFC
stand-alone assets and patents to the partnership. TEK-KOL was formed to own and
license the LFC Process technology. As a result of the Agreement and subsequent
partnership formation, the Company recorded the book value of its one-half
interest in the assets contributed, $412,000, as its investment in TEK-KOL. The
Company accounts for its investment in TEK-KOL using the equity method. TEK-KOL
became operational in 1995 and the Company has recorded $932,000, $463,000 and
$288,000 as its share of TEK-KOL's 1997, 1996 and 1995 net losses, respectively.

Capital contributions to TEK-KOL are expected to be required from time to time.
The partnership agreement requires the Company to contribute one-half of any
required capital contributions which is mutually determined by the partners. The
Company recorded a liability to TEK-KOL of $412,000 at December 31, 1995, for
the unpaid portion of the required contributions. The partners verbally agreed
that the Company was not in default of the partnership agreement provision
regarding payment of required capital contributions. The Company paid all
required capital contributions to TEK-KOL through December 31, 1997.

The partnership agreement originally designated the Company as licensing
contractor. To date, the Company has not been reimbursed for past licensing
related expenditures. The partnership agreement was amended effective May 1,
1995, so that the Company now receives 75% of all royalties, fees, and other
monies paid to TEK-KOL by third parties, until such time that the Company has
received $2.0 million. After the Company receives $2.0 million, all royalties,
fees, and other monies paid to TEK-KOL will be shared evenly. Ongoing licensing
activities by the Company will be compensated as determined by TEK-KOL. The
Company will record licensing revenues as these monies are received.

TEK-KOL granted the Company a royalty-free LFC Process license for cogeneration
plants with an aggregate capacity of 350 megawatts and a royalty-bearing LFC
Process license which requires the Company to pay royalties of approximately
12.5% of the net proceeds from the sale of liquids produced by its first two
sole LFC Projects. Royalties to TEK-KOL for all products produced by additional
SGI sole projects are subject to negotiation based on prevailing industry
practices.

TEK-KOL granted an LFC Process license to SMC through which TEK-KOL will receive
royalties of approximately 12.5% of the net proceeds from the sale of liquids
produced by the first Level I and Level II plants. Royalties to TEK-KOL for all
products produced by any subsequent SMC plants are subject to royalties
negotiated based on prevailing industry practices.

<PAGE>
                    SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


4. LFC Process Related Assets (continued)

Australia LFC Project The Company has capitalized certain costs associated with
preliminary site reviews and engineering studies relative to Australian coals as
part of an effort to market the LFC Process technology. The Company owns the
right to license the LFC Process technology in Australia and New Zealand. The
capitalized costs are being amortized over a ten year estimated life and
amortization expense of $29,000 was recorded during 1997, 1996, and 1995.
Accumulated amortization at December 31, 1997 and 1996 is $174,000 and $145,000,
respectively.


5. Line-of-Credit and Notes Payable

The Company established a $400,000 line-of-credit with a financial institution
during 1996. The line-of-credit is secured by a $402,500 certificate of deposit
maturing May 1998, and borrowings on the line-of-credit bear interest at 2% over
the certificate of deposit interest rate. Borrowings on the line-of-credit were
$400,000 at December 31, 1997.

Notes payable consist of the following:
<TABLE>

                                                                           December 31,
                                                             -----------------------------------
                                                                       1997          1996
                                                             -----------------------------------
<S>                                                               <C>            <C>
12% notes, due through September 2000, unsecured                    $ 26,125       $ 33,250
10-12% notes, due on September 30, 1998, unsecured                 3,050,000      4,207,000
12% convertible debentures due on September 30, 1998, unsecured      976,573             --
Non-interest bearing convertible debenture, due no earlier
  than 1999, unsecured                                               100,000        100,000
                                                             -----------------------------------
                                                                   4,152,698      4,340,250
Less current portion                                               4,038,448      4,216,500
                                                             ===================================
Long-term portion                                                  $ 114,250     $  123,750
                                                             ===================================
</TABLE>

During 1986 and 1987, the Company sold securities to qualified investors through
private placement offerings which included 12% notes payable. Principal payments
of $2,375 and 12% interest payments are due quarterly through maturity in
September 2000. The 12% notes payable also include contingent interest ranging
from 6% to 24%. The contingent interest begins accruing quarterly upon
completion of construction, start-up and testing of a commercial LFC Plant. No
commercial LFC Plants have been built and no interest expense related to this
contingency has been recorded to date. The notes are convertible into restricted
common stock at the rate of .075 shares per $1 of outstanding principal.
Prepayment of the principal results in the payment of an amount which would
cause the annual return from the original note date to become 18% to 24%,
compounded annually. An additional payment equal to 25% of the outstanding
principal is also required upon prepayment. The balance outstanding under these
notes totaled $26,125 at December 31, 1997.

Early in 1995, the Company sold Investment Units ("Units") through private
placement offerings to qualified investors for $10,100 per unit. Such Units
include a $10,000 note payable, bearing interest at rates of 10% to 12% per
annum and one convertible preferred share. The notes payable generally have
twelve to thirty-six month terms and interest is payable quarterly. The
preferred shares are convertible into common stock as described in Note 7. The
proceeds from the Units were allocated to the notes payable and preferred shares
based on their relative fair values which resulted in recording discounts to the
notes payable. Note discounts of $269,000 were amortized to interest expense
during 1995.

The Company made limited principal and interest payments in 1995 on the notes
payable issued through the Unit sales. In November 1995, the Company proposed a
note restructuring program to the noteholders pursuant to which the original
maturity date could be extended to September 1997, or the note principal could
convert into preferred stock. The notes payable were restructured during late
1995 and early 1996 as discussed below.

<PAGE>
                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


5. Line-of-Credit and Notes Payable (continued)

As of December 31, 1995, the original maturity dates for notes payable with a
carrying value of $4,034,000 were extended and notes payable with a carrying
value of $1,557,500 were converted into 155.75 Series 95R preferred shares with
a $10,000 per share liquidation preference. On November 1, 1997, 135.25 of the
preferred shares were convertible into 1,806,875 common shares and 20.5
preferred shares were convertible into common shares based on the fair market
value of the common stock on the date of conversion. At December 31, 1997, 81.75
preferred shares were converted into approximately 1,093,000 common shares and
an additional 1,006,000 common shares have been reserved for issuance. Certain
of the converting noteholders were granted warrants to purchase 39,250 shares of
common stock at $1.25 per share pursuant to terms of the restructuring.

In 1995, accrued interest of $121,000 was satisfied through the issuance of the
Series 95R preferred shares, accrued interest of $99,000 was satisfied through
the issuance of 88,838 restricted common shares, and accrued interest through
December 31, 1995, of $276,000 became due September 30, 1997. The Company also
prepaid interest through September 30,1996, of $94,000 on certain notes through
the issuance of 84,177 restricted commons shares.

During 1996, the original maturity dates for notes payable with a carrying value
of $165,000 were extended and notes payable with a carrying value of $725,000
were converted into 2.5 Series 95R preferred shares and 70 Series 96A preferred
shares, all with a $10,000 per share liquidation preference. The Series 95R
preferred shares are convertible into 33,750 common shares on November 1, 1997,
and the Series 96A preferred shares are convertible into 945,000 common shares
on May 1, 1998.

In 1996, accrued interest of $89,000 was satisfied through the issuance of the
Series 95R and 96A preferred shares, the Company prepaid interest through
September 30, 1997, of $62,200 on certain notes through the issuance of 14,288
restricted common shares, and accrued interest through December 31, 1996, of
$529,000 became due September 30, 1997.

In 1996, the Company granted the owner of a domestic research company a warrant
to purchase 100,000 restricted common shares at $1.72 per share in exchange for
a note payable previously issued by the Company, accrued interest and accounts
payable totaling $141,600.

The Company received $304,000 and $50,000 from an entity controlled by a
Director in 1995 and 1996, respectively, in exchange for 10% notes payable due
on December 31, 1996. In March 1996, the Company issued 283,200 restricted
common shares in satisfaction of the aggregate principal and accrued interest of
$375,000.

The Company received $230,000 from LFCTP in 1995 in exchange for 10% notes
payable due through 2000 and warrants to purchase 230,000 common shares at $1.00
per share. The notes payable were collateralized by the notes receivable
discussed in Note 4. In 1996, LFCTP exercised the warrant in exchange for the
previously issued note payable and the Company issued 230,000 restricted common
shares. Accrued interest of $18,000 on the notes was satisfied through the
issuance of 2,096 restricted common shares.

The Company received $100,000 from a foreign corporation in 1995 in exchange for
a non-interest bearing debenture with a $100,000 face value. The debenture is
due one year from the occurrence of certain future events, none of which
occurred to date. Accordingly, the debenture is classified as long-term debt in
the accompanying consolidated balance sheet. The debenture is convertible based
on future events, and would have converted into 24,807 common shares at December
31, 1996, had those events occurred.

On July 15, 1997, the Company converted one $10,000 note payable and associated
accrued interest of $2,748 into one share of Series 97C convertible preferred
stock. The convertible preferred share is fully paid and non-assessable, has no
voting rights, has a preference in liquidation of $10,000 and is convertible
into 13,500 shares of common stock on or after August 30, 1998, without further
payment.

<PAGE>

                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


5. Line-of-Credit and Notes Payable (continued)

In October 1997, the Company was able to extend, exchange or convert
approximately $4.8 million in existing debt for new securities of the Company
including common stock, warrants and revised, amended or new convertible debt
securities and also paid approximately $400,000 in existing debt. The Company
retired approximately $250,000 in existing 10%, 11% and 12% interest bearing
notes which were required to be paid by October 31, 1997, in exchange for
$250,000 of 12% convertible debentures due September 30, 1998, with a conversion
price of $1.20. The Company obtained an extension to September 30, 1998, of
approximately $3,428,000 of debt, and in connection therewith, agreed to grant
warrants to purchase an aggregate of 152,500 shares of common stock at an
exercise price of $1.20 per share for each quarterly period the debt remains
unpaid. The warrants expire one year from the date of issuance. The Company
retired an additional $727,000 of existing 10%, 11% and 12% interest bearing
notes which were required to be paid by October 31, 1997, in exchange for
$727,000 of convertible debentures due September 30, 1998, with a conversion
price of $1.20. In connection therewith, and in part as consideration for all
interest due through the maturity of the extended notes, the Company issued
95,439 shares of restricted common stock. The 12% convertible debentures are
convertible into approximately 814,000 shares of restricted common stock. No
note payments were made prior to December 31, 1997, and the Company issued
warrants to purchase 152,500 common shares, as previously discussed, to
noteholders. Imputed interest expense of $175,922 was recorded in connection
with the issuance of the 12% convertible debentures.

<TABLE>

Scheduled principal payments of notes payable are as follows:

                           Years ended December 31,
                 -------------------------------------------
                          <S>       <C>
                          1998      $ 4,038,448
                          1999          109,500
                          2000            4,750
                                   =================
                    Total payments  $ 4,152,698
                                   =================
</TABLE>


6. Acquisition of AMS and Information on Industry Segments

Acquisition

On October 30, 1995, the Company acquired AMS, a designer and manufacturer of
automated assembly equipment. For financial statement purposes the acquisition
was accounted for as a purchase and, accordingly AMS's results are included in
the consolidated financial statements since the date of acquisition. The
aggregate consideration of approximately $1,395,000 included approximately
$1,047,000 of certain liabilities assumed, $18,000 of acquisition costs and
three Series 95 convertible preferred shares valued at $330,000 in exchange for
100% of the outstanding common stock of AMS. The excess of the purchase price
over the fair value of the assets acquired ("Goodwill") approximated $479,000.

Pro forma results of the Company's operations, assuming the acquisition had
occurred as of January 1, 1994, are presented below:

<TABLE>

                                        1995            1994
                                   --------------- ----------------
<S>                                  <C>             <C>
Net revenue                          $ 4,865,000     $ 6,184,000
Net loss                               7,258,000       6,093,000
Net loss per share                          2.64            3.15
</TABLE>

In management's opinion, the pro forma consolidated results of operations do not
purport to be indicative of the actual results that would have occurred had the
acquisition been consummated at the beginning of fiscal 1995 or at the beginning
of fiscal 1994 or of future operations of the consolidated companies under the
ownership and management of the Company.

<PAGE>
                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


6. Acquisition of AMS and Information on Industry Segments (continued)

Segment Information

The following table presents relevant information for AMS as a whole for the
years ended December 31, 1997, 1996, and the period from October 31, 1995, to
December 31, 1995:
<TABLE>

                              1997             1996             1995
                         --------------- ---------------- -----------------
<S>                       <C>              <C>                <C>
Sales                     $ 5,280,000      $ 3,939,000        $ 867,000
Income from operations      1,353,000          498,000          238,000
Total assets                1,403,000        1,527,000        1,297,000
Accum. Depreciation            82,000           34,000            1,000

</TABLE>

AMS operates in three segments of the automated assembly systems industry:
High-Tech, medical and automotive. The sales for 1997 and 1996 are presented
below, 1995 information is not provided as management believes that two months
of operations would not be meaningful.
<TABLE>

                              1997             1996
                         ---------------  ----------------
<S>                       <C>              <C>
High-Tech                 $ 2,967,000        $ 943,000
Medical                       717,000        1,028,000
Automotive                  1,596,000        1,968,000
                         ---------------  ----------------
Total Sales               $ 5,280,000      $ 3,939,000
                         ===============  ================
</TABLE>

Sales revenue was derived primarily from contracts to manufacture assembly
equipment with three, four and two customers in 1997, 1996 and 1995,
respectively. Revenue from sales of automated assembly equipment accounted for
99%, 93% and 96% of the Company's revenues in 1997, 1996 and 1995, respectively.
In each of the past three years, no single customer has accounted for more than
10% of sales on a consistent basis. AMS does not have long-term contracts with
any of its customers and expects that a small number of customers will continue
to account for a substantial portion of its sales for the foreseeable future.


7. Stockholders' Equity (Deficiency)

Convertible Preferred Stock A summary of the issued and outstanding convertible
preferred stock at December 31, 1997, is as follows:

<TABLE>
                                                                       Common shares
                               Shares issued        Preference in         issuable
                              and outstanding        liquidation        on conversion
                            ------------------- ------------------- ----------------------
<S>                             <C>                  <C>                <C>
Series P-90 Preferred Stock        400                 $  40,000           100,000
Series PS90 Preferred Stock          8                     2,000             1,000
Series 90 Preferred Stock            6                       640               560
Series 91 Preferred Stock       87,655                   346,440             7,520
Series 92 Preferred Stock           18                     1,810               130
Series 93 Preferred Stock           74                     7,350             2,700
Series 94 Preferred Stock          250                    24,995            10,624
Series 95 Preferred Stock           75                   856,111         1,094,963
Series 96 Preferred Stock          105                 1,155,000         1,050,000
Series 97 Preferred Stock        2,406                 2,415,000         2,666,078
                            ================== =================== ======================
                                90,997                $4,849,346         4,933,575
                            ================== =================== ======================
</TABLE>

During 1997, shareholders elected to convert 1,141 Preferred Shares into
approximately 2,155,000 shares of common stock.

<PAGE>

                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


7. Stockholders' Equity (Deficiency) (continued)

In April 1997, the Company executed a funding agreement with certain foreign
accredited investors which provided for the sale of the Company's common stock
in three tranches of $1,000,000 each, pursuant to Regulation S. On May 30, 1997,
this agreement was modified and the Company issued 1,000 shares of $.01 par
value 8% Convertible Preferred Series 97B stock and ten warrants to purchase
30,000 shares at $2.30 per share to four foreign accredited investors for an
aggregate $1,000,000. The 97B Preferred Shares accrued dividends at a rate of 8%
per annum and were cumulative. The dividend was only payable in common stock of
the Company. The warrants were immediately exercisable and expire on May 30,
2002. As of December 31, 1997, all the preferred shares had been converted into
756,006 common shares of the Company. Imputed dividends aggregating $236,419
were recorded in connection with the issuance of the 97B Preferred shares. The
imputed dividends have been included in the computation of net loss per share as
disclosed in Note 1 to the consolidated financial statements.

On July 15, 1997, the Company converted one $10,000 note payable with accrued
interest of $2,748 by issuing one share of Series 97C convertible preferred
stock. The convertible preferred share has no voting rights, has a preference in
liquidation of $10,000 and is convertible into 13,500 shares of common stock on
or after August 30, 1998, without further payment.

On August 12, 1997, the Company issued 550 shares of $.01 par value, 7%
Convertible Preferred Series 97D and six warrants with an exercise price of
$2.44 per share, for net proceeds of approximately $505,000. These shares have a
liquidation preference of $1,000 per share. The number of common shares to be
issued upon conversion of the preferred shares will be determined by dividing
the amount invested by the lesser of (a) the average closing bid price for the
five trading days preceding the closing date or (b) the product of 77.5%
multiplied by the average of the closing bid price for the five trading days
preceding the conversion date. The six warrants are exercisable at the average
closing bid price for the five trading days preceding the closing date. Three
warrants representing 205,128 each of common stock each expire 60 days, 120 days
and 180 days respectively, subsequent to the underlying common shares being
included in an effective registration statement with the Securities and Exchange
Commission ("SEC"), but no later than 545 days from closing date. Another three
warrants representing 20,513 shares of common stock each expiring 60 days, 120
days and 180 days respectively, subsequent to the effective date of the
registration with the SEC, but no later than 545 days from closing date. The
warrants were exercisable August 22, 1997. The 97D Preferred Shares accrue
dividends at a rate of 7% per annum and are cumulative. The dividend is only
payable in common stock of the Company. Imputed dividends aggregating $144,654
were recorded in connection with the issuance of the 97D Preferred Shares. The
imputed dividends have been included in the computation of net loss per share as
disclosed in Note 1 to the consolidated financial statements.

On November 6, 1997, the Company issued 1,750 shares of $.01 par value, 8%
Convertible Preferred Stock Series 97F to certain foreign investors, and five
warrants, to five purchasers for $1,000 per share for an aggregate purchase
price of $1,750,000. The number of shares of common stock underlying the 97F
Preferred shares and warrants are subject to a Registration Rights Agreement
which entitles the purchasers to demand registration upon written notice to the
Company. The Company is required to register 200% of the number of shares that
would be required if all of the 97F Preferred Shares were converted, assuming a
conversion date 5 days prior to the filing of the registration statement with
the SEC. The number of common shares to be issued upon conversion of the 97F
Preferred Shares will be determined by dividing the amount invested by the
lesser of: (a) the average closing bid price for the five trading days preceding
the closing date or (b) the product of 75% multiplied by the average of the
closing bid price for the five trading days preceding the conversion date. The
five warrants which are convertible into 70,000 shares of common stock, contain
a conversion price equal to 110% of the average closing bid price for the five
trading days preceding the closing date. The warrants all expire on November 6,
2002.



<PAGE>


                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


7. Stockholders' Equity (Deficiency) (continued)

The 97F Preferred Shares accrue dividends at the rate of 8% per annum and are
cumulative. The dividend is only payable in common stock of the Company. The 97F
Preferred Shares have a liquidation preference of $1,000 per share and are
convertible at the earlier of: (i) the date a registration statement including
the underlying common shares is declared effective or (ii) sixty one days from
the closing date (November 6, 1997). If the registration statement is not
declared effective by the SEC by the 61st day following the date of the demand
registration, the purchasers, at their option may either: (a) convert up to 50%
of their investment in the 97F Preferred Shares, pursuant to Regulation S or (b)
if the Company qualifies to register the Securities under Form S-3, require the
Company to pay certain specified damages in cash. Furthermore, if the Company
qualifies to file under Form S-2b and the registration statement is not declared
effective by the SEC by the 121st day following the date of the demand
registration the Purchasers, at their option may either: (a) convert all or part
of their remaining investment in the 97F Preferred Shares, pursuant to
Regulation S and/or (b) require the Company to pay certain specified damages in
cash. The 97F Preferred Shares are redeemable at the option of the Company, in
whole or in part, in cash, at 130% of the Liquidation value plus accrued and
unpaid dividends. The 97F Preferred Shares will automatically convert into
common stock two years from the closing date.

In connection with the sale of the 97F Preferred Shares, the Company paid two
unaffiliated placement agents, fees consisting of $70,000 in cash, 105 shares of
97F Preferred Shares having a value of $105,000, and warrants to purchase 35,000
shares of common stock as compensation for placement. The warrants contain a
conversion price equal to 110% of the average closing bid price for the five
trading days preceding November 6, 1997. The warrants all expire on November 6,
2002. In addition, the Company paid $8,750 in cash for legal and escrow fees
incurred in connection with this transaction. The net proceeds to the Company of
$1,671,250 will be used for working capital and the continuous research and
development of the OCET and LFC processes. Imputed dividends aggregating
$389,153 were recorded in connection with the issuance of the 97F Preferred
Shares. The imputed dividends have been included in the computation of net loss
per share as disclosed in Note 1 to the consolidated financial statements.

The Series 96 convertible preferred shares are non-voting, and were issued in
connection with the note restructuring discussed in Note 5 and the FLP
transaction discussed in Note 4. The Series 96B preferred shares have certain
registration rights, and are convertible without further payment on the earlier
to occur of the filing of a registration statement including the underlying
common shares or August 30, 1998.

The Series 95 convertible preferred shares are non-voting, and were issued in
connection with private placements, the note restructuring discussed in Note 5
and the AMS acquisition discussed in Note 6. In 1995, the Company raised
$1,114,000, net of offering costs of $137,500, through the issuance of 125,000
Series 95 convertible preferred shares and the issuance of two Series 94
convertible preferred shares. The Series 95 preferred shares were convertible
after forty-one days into common shares based on the common stock closing bid
price on various dates in 1995. During 1996, 17,500 Series 95 preferred shares
were converted into 21,875 common shares, and during 1995, 107,500 Series 95
preferred shares were converted into 126,421 common shares.

The Series 94, 93, 92, 91 and 90 preferred shares were issued in connection
with the Unit sales discussed in Note 5. All Series 94 through 90 preferred
shares are non-voting, and callable at $100 per share except the Series 91 and
Series 90 preferred shares.

Certain of the Series 91 convertible preferred shares provide cumulative
dividends ranging from $8 to $800 per share, and are callable at $100 per
preferred share plus any unpaid cumulative dividends.

The Series 90 preferred shares provide an $8 cumulative dividend per share, and
are callable at $100 per share plus any unpaid cumulative dividends.



<PAGE>


                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


7. Stockholders' Equity (Deficiency) (continued)

The Series PS90 convertible preferred shares were issued in 1990 to employees of
the Company and are convertible into restricted common shares upon payment of
$1.375 per common share. The Series PS90 preferred shares are non-voting, have a
preference in liquidation of $250 per share and provide a $20 cumulative
dividend per share.

The Series P-90 convertible preferred shares were issued in 1990 to two Board
members who were also Company officers, and are convertible into restricted
common shares upon an additional payment of $1.375 per common share. The Series
P-90 preferred shares are non-voting, provide an $8 cumulative dividend per
share, and are callable after January 1, 1995, at $100 per share plus any unpaid
cumulative dividends.

Dividends on all preferred shares are only payable when the Company has
sufficient accumulated earnings. Cumulative dividends of $93,000 were in arrears
under the Series 97, 91, PS90, 90 and P-90 preferred share agreements at
December 31, 1997.

Common Stock

In January 1997, the Company issued one individual and one domestic corporation
11,250 and 26,500 common shares, respectively, as compensation for placement
agent services.

The Company executed a stock purchase agreement with a foreign accredited
investor on April 15, 1997, which provided for the sale of the Company's common
stock in five weekly tranches aggregating $1,000,000. Pursuant to this agreement
the Company issued 537,320 shares of common stock. The number of shares in each
tranch was determined by dividing the amount invested by the product of 75%
multiplied by the average of the closing bid price for the five trading days
preceding the investment.

During April 1997, the Company raised $29,735, net of discounts aggregating
$24,329, through the issuance of 15,008 restricted common shares to one
employee.

In May 1997, the Company issued 112,000 restricted common shares to a domestic
entity for financial consulting services rendered, valued at $161,700.

On December 11, 1997, the Company issued 25,714 shares of restricted common
shares and two warrants to acquire an aggregate of 37,714 of common shares at
$5.75 per share to AEM as more fully disclosed in Note 4.

Throughout the year ended December 31, 1997, the Company issued 36,088
restricted common shares to seven domestic individuals pursuant to Regulation D
for services rendered and recorded compensation expense of approximately
$108,000.

During 1996, the Company raised $2,596,000 through the issuance of 1,377,306
restricted common shares. The Company issued 49,626 restricted common shares for
services and recorded compensation expense of $65,000 in 1996. As discussed in
Note 5, the Company issued restricted common shares in exchange for notes
payable, accrued interest, and future interest obligations.

During 1995, the Company raised $1,024,000, net of offering costs of $48,000,
through the issuance of 963,035 restricted common shares. The Company issued
216,088 restricted common shares for services and recorded compensation expense
of $289,000 in 1995. As discussed in Note 5, the Company also issued restricted
common shares for accrued interest and future interest obligations.

Warrants and Options The following table summarizes disclosures required by
SFAS 123 for warrant and option activity subsequent to December 31, 1994:
--------------------



<PAGE>


                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


7. Stockholders' Equity (Deficiency) (continued)

Common shares underlying outstanding warrants and options

<TABLE>

                                          Underlying Common    Weighted-average
                                                Shares           exercise price
                                     ----------------------------------------------
<S>                                          <C>                     <C>
Balance, January 1, 1995                        222,208              $15.72
Granted                                       1,768,816                1.83
Exercised                                      (274,829)               1.16
Expired                                         (16,925)              21.85
                                        ----------------
Balance, December 31, 1995                    1,699,270                1.91

Granted                                       1,310,100                3.75
Forfeited                                       (24,816)               1.50
Exercised                                      (473,528)               1.06
Expired                                          (3,450)              50.00
                                        ----------------
Balance, December 31, 1996                    2,507,576                2.97

Granted                                       2,050,610                1.85
Exercised                                      (150,000)               0.94
Expired                                          (6,411)              46.74
                                        ================
Balance, December 31, 1997                    4,401,775                2.18
                                        ================
</TABLE>

As provided in related service agreements, the Company granted warrants to
purchase 545,250 common shares to 39 employees during 1997 pursuant to
Regulation D. The warrant exercise prices were not lower than the closing bid
price on the grant dates. The warrants all expire on December 31, 2001, and are
exercisable one year from the grant date. The exercise price for the warrants is
$1.03 per share.

As provided in related agreements, the Company granted warrants to 9 consultants
to purchase 187,223 common shares during 1997 pursuant to Regulation D in return
for services valued at $208,063. In addition, the Company issued warrants to
purchase 1,082,137 common shares in conjunction with the various financings
throughout the year, as more fully disclosed in Note 5 and here in Note 7 of the
consolidated financial statements.

The Company changed the exercise prices for 2,667,153 shares to exercise prices
of $20.00 to $.875 per share from exercise prices of $1.375 to $.60 per share in
1995. The Company changed the exercise prices for 844,500 shares to an exercise
price of $1.03 per share from exercise prices of $1.72 to $4.375 per share in
1997. The repricings changed the exercise price to the then current common stock
closing bid price.

The weighted average grant date fair market value of warrants and options
granted in 1997 and 1996 are $1.48 and $2.64 per share, respectively. All
warrants and options granted , are not subject to repurchase by the Company.
Approximately 1.9 million common shares underlying warrants and options have
been registered with the SEC as of December 31, 1997.

The following table provides the weighted-average exercise price and the
weighted-average remaining contractual life for outstanding warrants and options
at December 31, 1997, grouped into three exercise price ranges.

<TABLE>

               Warrants and Options Outstanding Warrants and Options Exercisable
----------------------------------------------- ---------------------------------------------
                     Number      Wt. Avg.     Wt. Avg.     Number       Wt. Avg.    Wt. Avg.
                  Outstanding   Remaining    Exercise    Exercisable   Remaining    Exercise
    Range         at 12/31/97  Life (Years)    Price     at 12/31/97  Life (Years)   Price
--------------- ------------- ------------- ----------- ------------- ------------ ------------

<S>                 <C>             <C>       <C>          <C>            <C>        <C>
$.60 - $2.438       3,635,858       3.6       $ 1.32     1,845,185        3.2        $ .95
$3.55 - $10.00        736,977       5.5         5.54       637,040        5.6         5.67
$18.00 - $47.50        28,941       1.5        25.54        28,941        1.5        25.54

</TABLE>

<PAGE>
                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


7. Stockholders' Equity (Deficit) (continued)

Pro Forma Information As of December 31, 1997, the Company has outstanding
warrants and options as described above. The Company has elected to follow APB
25 and related interpretations in accounting for the warrants and options. Under
APB 25, because the exercise price of the Company's warrants equals the market
price of the underlying stock on the grant date, no compensation expense is
recorded.

Pro forma information regarding net loss and net loss per share is required by
SFAS 123, and has been determined as if the Company had accounted for the
warrants and options granted subsequent to December 31, 1994 under the fair
value method of SFAS 123. The fair value for these options was estimated at the
grant date using a Black-Scholes option pricing model with the following
weighted-average assumptions for 1995, 1996, and 1997, respectively: risk-free
interest rate of approximately 6% for all years; volatility factor of the
expected market price of the Company's common stock ranging from .737 to 1.631,
1.604 to 1.721, and 1.5; weighted-average expected life of the option of 2.0
years for all years, and a dividend yield of zero for all years.

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's warrants and options have characteristics significantly different
from those of traded options, and because changes in the subjective input
assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of the Company's warrants and options. For purposes of
pro forma disclosures, the estimated fair value of the warrants and options
expensed during the grant year. The Company's historical and pro forma
information follows (in thousands, except for net loss per share information):

<TABLE>

                                  Years ended December 31,
                         ------------ ------------- --------------
                             1997          1996         1995
                         ------------ ------------- --------------
<S>                        <C>           <C>            <C>
Netloss
   Historical              ($6,479)      ($4,259)      ($6,825)
   Pro Forma                (7,858)       (6,859)       (8,918)

Net loss per share-basic
   Historical               $(0.88)       $(0.80)       $(2.46)
   Pro Forma                 (1.07)        (1.28)        (3.21)

</TABLE>

The Company granted warrants to employees for the purchase of 3,530,000 OCET
common shares at $1.00 per share in 1995, and canceled a warrant for 850,000 of
those shares in January 1996. There is no current market for OCET common stock.
At December 31, 1997, warrants for the purchase of 2,680,000 OCET common shares
are exercisable. All warrants to purchase OCET common shares expire December 31,
1999. No compensation expense was recorded in 1995 related to the OCET warrants,
as the Company and its subsidiaries account for warrants and options in
accordance with APB 25. The fair market value of the OCET warrants was estimated
at the grant date using a Black-Scholes option pricing model with the following
assumptions: risk free interest rate of 6%; volatility factor of zero as OCET is
a non public entity; expected life of 4 years and a dividend yield of zero. The
resulting compensation expense of approximately $35,000 was included in the SFAS
123 pro forma disclosure.




<PAGE>


                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


8. Stock Option and Performance Incentive Program

On May 23, 1997, the stockholders approved the 1996 Omnibus Stock Option Plan
(the "Stock Plan") pursuant to which a maximum aggregate of 2,000,000 shares was
reserved for grant. Under the Stock Plan, employees may be given an opportunity
to purchase, by way of option, or stock purchase rights, common stock of the
Company. The Stock Plan also provides for the use of stock appreciation rights
and on term performance awards as employee incentives. The terms and conditions
of each award are at the discretion of the Board of Directors or any duly
authorized committee.

On September 11, 1997, the Company granted incentive stock options, pursuant to
the Stock Plan, exercisable for a total of 236,000 shares of common stock at
$1.03 per share to employees. The options are exercisable upon effective
registration under the Securities Act of 1933 or one year from the date of
issuance. The options shall expire on September 11, 2007 and are fully vested to
employees with one year of service. The Company applies APB 25 and related
interpretations in accounting for its plan. In accordance with SFAS 123, as more
fully described in Note 7, the options have been aggregated with the warrants
for the fair value pro forma disclosure required.


9. Related Party Transactions

SGI has entered into the following transactions with related parties:

(a) The Company sold 200 Series P-90 preferred shares for $22,000 to two
officers in 1990. Each preferred share is convertible into 250 restricted
common shares upon payment of a price that was reduced from $15.00 per
share to $1.375 per share in 1995.

(b) The Company granted warrants to purchase a total of 820,000 common shares
to officers and directors in 1996, 1995, and 1994 at exercise prices
ranging from $0.875 to $40.00 per share. The exercise prices equaled or
exceeded the closing bid price on the grant dates. During 1995, the
exercise prices of warrants to purchase 498,500 and 70,000 common shares
were changed to $0.60 and $1.375, respectively (Note 7).

(c) During 1995 and 1996, the Company issued 10% notes payable totaling
$354,000 to an entity controlled by a Board member. The notes and accrued
interest were converted into 283,200 restricted common shares in 1996.
Also during 1995, an officer advanced the Company a total of $52,000 and
was repaid.

(d) The Company had receivables from two officers of $398,000 at December 31,
1994. A portion of this receivable was offset by obligations of the
Company to both of the officers and the remaining $224,000 was reserved
at December 31, 1995. In January 1996, the Company agreed to forgive the
loans made to a former officer.

(e) The Company has an agreement with an officer/stockholder for the
assignment of his patent to the Company. The agreement provides for a
royalty equal to the greater of (i) $50,000 per calendar year or (ii)
one-tenth of one percent (.1%) of royalty revenues received by the
Company (or any joint venture of which the Company is a partner) through
December 31, 2000, conditioned only upon the continued practice of the
LFC Process technology during such period by the Company and/or any such
joint venture. The Company recognized royalty expense of $50,000 in each
of the years ended December 31, 1995, and 1994. During 1996, the
officer/stockholder agreed to forego all past and future royalty payments
pursuant to the agreement. The accrued liability of $142,000 at December 31,
1995, was recorded as other income in 1996.

(f) Three employees exercised warrants in August 1995 for 274,154 common
shares in exchange for notes payable of $308,000. The 8% notes were
non-recourse and were payable on August 23, 1999, only if the bid price
for the Company's common stock was in excess of $3.00 per share on that
date. As of January 1995 the employees had pledged 321,341 restricted
common shares as collateral for the notes payable. During the first
quarter of 1996, the Company recorded compensation expense of $474,000
related to these

<PAGE>
                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


9. Related Party Transactions (continued)

transactions as provided by Emerging Issues Task Force Abstracts Issue
No. 95-16, "Accounting for Stock Compensation Arrangements with Employer
Loan Features under APB Opinion No. 25." The compensation expense was
determined as the product of the aggregated common shares issued upon
exercise and the difference between the market price of the common stock
and the exercise price of the warrants. During the second quarter of
1996, the three employees exchanged 8% recourse notes payable August 23,
1999, for the non-recourse notes. The Company collected all principal and
interest payments prior to December 31, 1996, and the note activity is
reflected in the accompanying consolidated balance sheets as a component
of stockholders' equity (deficiency).

(g) As of December 31, 1997, the Company owed an officer/director approximately
$121,000 in deferred compensation.


10. Commitments and Contingencies

(a) The Company leases its corporate offices under an operating lease
agreement which provides for annual escalation of rental payments and
expires in December 2000. The Company's OCET subsidiary leases its
laboratory facilities under an operating lease agreement which expires in
May 2000. AMS leases its manufacturing facility under an operating lease
agreement which expires in October 1998. Under the terms of the lease
agreements, the lessee pays taxes, maintenance and insurance. As of
December 31, 1997, the Company had no other significant commitments under
capital or operating leases. Total rent expense relating to leased
facilities was approximately $387,000, $316,000 and $226,000 in 1997,
1996, and 1995, respectively.

Future minimum annual operating lease commitments are as follows:

<TABLE>
                                        Year ending December 31,
                              -----------------------------------------
                                   <S>                  <C>
                                   1998                 $355,000
                                   1999                  231,000
                                   2000                  160,000
                                                         -------
                                                        $746,000
                                                        ========
</TABLE>

(b) As discussed in Note 4, the Company is required to make contributions to the
TEK-KOL Partnership.

(c) The Company has employment agreements with its executives, the terms of
which expire on December 31, 1998. Such agreements, which have been
revised from time to time, provide for minimum salary levels. The
agreements contain change-in-control provisions that would automatically
extend the date of the employment agreements by one year from the date of
change. The maximum contingent liability under agreements, in such event,
is approximately $1.1 million.

(d) The Company and its subsidiaries are from time to time involved in
litigation arising in the ordinary course of their respective
businesses. The only lawsuit currently pending against the Company is
Walsh vs. AMS, which relates to events occurring prior to the
acquisition of AMS by the Company. The lawsuit asserts claims, for among
other things, breach of contract relating to a loan of approximately
$300,000. AMS has filed an answer denying liability and discovery is
proceeding. In the opinion of the Company the pending litigation, if
adversely decided, should not have a material adverse effect on the
Company.



<PAGE>


                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


11. Income Taxes

The significant components of the Company's deferred tax assets and liabilities
are:
<TABLE>

                                                       1997           1996

                                             -------------------------------------
<S>                                               <C>             <C>
Deferred tax assets:
  Net operating loss carryforwards                $ 18,623,000    $ 17,295,000
  Depreciation and amortization                        658,000         583,000
  Research and development credits                     419,000         380,000
  Accrued interest                                     192,000         217,000
  Stock for services                                   134,000          27,000
  Other                                                109,000          24,000
                                             -------------------------------------
                                                    20,135,000      18,526,000
Deferred tax liabilities:
  Other                                               (728,000)       (731,000)
                                             -------------------------------------
Net deferred tax assets                             19,407,000      17,795,000
Deferred tax assets valuation allowance            (19,407,000)    (17,795,000)
                                             -------------------------------------
                                                  $          -   $           -
                                             =====================================

</TABLE>


At December 31, 1997, the Company had net operating losses available for
carryforward for federal and state tax purposes of approximately $50,689,000
million and $15,714,000 million respectively. Federal and state loss
carryforwards of $87,000 and $7,331,000, respectively expired in 1997 and will
not be available for carryforward into 1998. The difference between federal and
state loss carryforwards is primarily attributable to the 50% limitation of
California loss carryforwards. The Company also has federal research credit
carryforwards of approximately $350,000 which will begin to expire in 2004
unless previously utilized.

At December 31, 1997, the Company had net operating loss carryforwards
for federal and state tax purposes expiring as follows:
<TABLE>

Year Expires                       Federal         State
--------------------------------   --------------  -------------
<S>                                <C>              <C>
1998                                $ 1,008,000     $  2,925,000
1999                                    343,000        4,645,000
2000                                    368,000        3,879,000
2001                                    849,000        1,979,000
2002                                  1,151,000        2,286,000
2003                                  1,217,000                -
2004                                  6,984,000                -
2005                                  2,288,000                -
2006                                  3,750,000                -
2007                                  8,111,000                -
2008                                  5,723,000                -
2009                                  5,057,000                -
2010                                  4,614,000                -
2011                                  4,654,000                -
2012                                  4,572,000                -
---------------------------------- --------------  -------------
Total loss carryforwards           $ 50,689,000      $15,714,000
---------------------------------- --------------  -------------
</TABLE>


12. Subsequent Events

On January 8, 1998, the Company, for the net proceeds of $490,000 issued 550
shares of Series 97G 8% Convertible Preferred Stock to two foreign accredited
investors pursuant to the provisions of Regulation S. The series 97G Preferred
Shares accrue dividends at a rate of 8% per annum and are cumulative. The
dividend is only payable in common stock of the Company. As per the subscription
agreements, the Company also issued warrants to purchase a total of 25,000
common shares at $1.35 per share and 194,502 shares of restricted common stock.
The Series 97G Preferred Stock is convertible, at any time 41 days after the
closing date of January 8, 1998. Each Series 97G share is convertible into the
number of shares of common stock derived by

<PAGE>

                       SGI International and Subsidiaries
             Notes to Consolidated Financial Statements (continued)


12. Subsequent Events (continued)

dividing the conversion rate by the conversion price. The conversion rate is the
liquidation preference of $1,000 per share of Series 97G Preferred Stock. The
conversion price is determined based on the date the conversion notice is
received and is equal to the lesser of (a) the average closing bid price of the
common stock over the five day trading period prior to the closing date or (b)
75% of the average of the closing bid price of the common stock on the five
trading days ending on the date preceding the conversion notice. The warrants
are exercisable 10 days subsequent to the closing date and expire on January 8,
2003. The 97G Preferred Shares are redeemable at the option of the Company, in
whole or in part, in cash, at 130% of the Liquidation value plus accrued and
unpaid dividends. The 97G Preferred Shares will automatically convert into
common stock two years from the closing date.

On January 14, 1998, the Company granted incentive stock options, pursuant to
its 1996 Omnibus Stock Plan, exercisable for a total of 225,000 shares of common
stock at $0.843 per share to employees of the Company. The options are
exercisable upon effective registration under the Securities Act of 1933 or one
year from the date of issuance. The options expire on January 14, 2003. These
securities were issued pursuant to the exemptions provided by Section 4(2) of
the Securities Act and Regulation D. Investment representations were obtained
from the investors and legends were placed on the certificates.

On March 6, 1998, the Company for net proceeds of $1,980,000, issued 2,200
shares of Series 98A Convertible Preferred Stock to two accredited investors. As
per the subscription agreements the Company also issued warrants to purchase a
total of 90,000 common shares at $1.27 per share. The Series 98A Preferred Stock
is convertible, at the earlier of the date the underlying common shares are
included in a registration statement which has been declared effective by the
SEC, or sixty days from the closing date, March 6, 1998. Each Series 98A share
is convertible into the number of shares of common stock derived by dividing the
conversion rate by the conversion price. The conversion rate is the liquidation
preference of $1,000 per share of Series 98A Preferred Stock. The conversion
price is determined based on the date the conversion notice is received and is
equal to the lesser of (a) the average closing bid price of the Common Stock
over the five day trading period prior to the closing date or (b) 75% of the
average of the closing bid price of the common stock on the five trading days
ending on the date preceding the conversion notice. The warrants were
exercisable immediately and expire on March 6, 2003. The 98A Preferred Shares
are redeemable at the option of the Company, in whole or in part, in cash, at
130% of the Liquidation value plus accrued and unpaid dividends. The 98A
Preferred Shares will automatically convert into common stock two years from the
closing date. These securities were issued pursuant to the exemptions provided
by Section 4(2) of the Securities Act and Regulation D. Investment
representations were obtained from the investors and legends were placed on the
certificates.


ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

In November 1997, the Company changed its certifying accountants from Ernst &
Young LLP to J.H. Cohn LLP as reported in its Current Report on 8-K filed with
the Securities and Exchange Commission on November 26, 1997.


<PAGE>


PART III

The information required by this Part III will be provided in the Company's
definitive proxy statement for the Company's 1998 Annual Meeting of Shareholders
(involving the election of Directors), which definitive proxy statement will be
filed pursuant to Regulation 14A no later than April 30, 1998, and is
incorporated herein by this reference to the following extent:

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT

Reference is made to the information appearing under the captions "Election of
Directors - Information about Nominees and Executive Officers" and "Compliance
with Section 16 of the Securities Exchange Act of 1934" in the Company's Proxy
Statement.

ITEM 11. EXECUTIVE COMPENSATION

Reference is made to the information appearing under the captions "Information
Concerning Board of Directors - Compensation of Directors," and "Executive
Compensation" in the Company's Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Reference is made to the information appearing under the caption "Security
Ownership of Certain Beneficial Owners and Management" in the Company's Proxy
Statement.

ITEM 13. CERTAIN TRANSACTIONS

Reference is made to the information appearing under the caption "Certain
Relationships and Related Transactions" in the Company's Proxy Statement.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) 1&2 Financial Statements

See Index to Consolidated Financial Statements on page 26 hereof.

Financial Statement schedules for which provision is made under the
applicable accounting regulations of the SEC are not required under the
related instructions or are inapplicable and therefore have been
omitted.

(a) 3 Listing of exhibits

2.1 Merger Agreement between VDI and Genesis(2)
3.1.1 Articles of Incorporation, as amended(1)
3.1.2 Restated Articles of Incorporation(5)
3.1.3 Articles of Amendment to the Articles of Incorporation of SGI
International(26)
3.2.1 By-laws, as amended(2)(3)
3.2.2 Amended and Restated By-laws(5)
3.2.3 By-Laws, as Amended (9/20/90)(14)
4.1.1 Form of Warrants - Authorized Before 1987(1)
4.1.2 Form of Warrants - Series A through H(5)
4.1.21 Form of Amended Warrants(15)
4.1.22 Form of Amended Warrants(16)
4.1.3 Form of Warrants - Series I, M, S and P(5)
4.1.4 Form of Warrants - Series XX(12)
4.2 Loan Agreement with Arthur & Sophie Brody(4)
4.3 Form of Series 86-B Promissory Notes(4)
4.4 Form of Series 86-C Promissory Notes(4)
4.5 Form of Series 90-A Units (Promissory Note and Preferred stock)(14)
4.6 Form of Series 90-B Units (Promissory Note and Preferred Stock)(14)
4.7 Form of Series 90-C Units (Promissory Note and Preferred Stock)(14)
4.8 Form of Series 90-D Units (Promissory Note and Preferred Stock)(14)
4.9 Form of Series P90 Preferred Stock(14)
4.10 Form of Series PS90 Preferred Stock(14)
4.11 Form of Series 91-A Units (Promissory Note and Preferred Stock)(17)
4.12 Form of Series 91-AA Units (Promissory Note and Preferred Stock)(17)
4.13 Form of Series 91-B Units (Promissory Note and Preferred Stock)(17)
4.14 Form of Series 91-C Units (Promissory Note and Preferred Stock)(17)
4.15 Form of Series 91-D Units (Promissory Note and Preferred Stock)(17)
4.16 Form of Series 91-E Units (Promissory Note and Preferred Stock)(17)
4.17 Form of Series 91-V Units (Promissory Note and Preferred Stock)(17)
4.18 Form of Series 91-P Preferred Stock(17)
4.19 Form of Series 91-R Preferred Stock(17)
4.20 Form of Series 91-S Preferred Stock(17)
4.21 Form of Series 91-T Preferred Stock(17)
4.22 Form of Series 91-M Preferred Stock(17)
4.23 Form of Series 92-A Preferred Stock(19)
4.24 Form of Series 92-B Preferred Stock(19)
4.25 Form of Series 93-A Units (Promissory Note and Preferred Stock)(22)
4.26 Form of Series 93-B Units (Promissory Note and Preferred Stock)(22)
4.27 Form of Series 93-C Units (Promissory Note and Preferred Stock)(22)
4.28 Form of Series 94-A Units (Promissory Note and Preferred Stock)(23)
4.29 Form of Series 94-B Units (Promissory Note and Preferred Stock)(23)
4.30 Form of Series 94-C Units (Promissory Note)(23)
4.31 Form of Series 95-C Convertible Preferred Stock (25)
4.32 Form of Series 95-D1 Redeemable Convertible Preferred Stock (25)
4.33.1 Form of Series 95-D1.03 Convertible Preferred Stock (26)
4.33.2 Form of Series 95-D1.04 Convertible Preferred Stock (26)
4.34 Form of Series 95-E Redeemable Convertible Preferred Stock (25)
4.35 Form of Series 95-R Convertible Preferred Stock (26)
4.36 Form of Series 96-A Convertible Preferred Stock (28)
4.37 Form of Series 96-B Convertible Preferred Stock (28)
4.38 Certificate of Secretary re: Designation of Series 97-C Preferred
Stock.(29)
4.39 Certificate of Secretary re: Designation of Series 97-D Preferred
Stock.(29)
4.40 Form of Debenture for Series 97-E.(29)
4.41 Form of Warrant for Series 97-E.(29)
4.42 Certificate of Secretary re: Designation of Series 97-F Preferred
Stock.(29)
4.43 Amended Certificate of Secretary re: Designation of Series 97-G Preferred
Stock.(29)
4.44 Form of Common Stock Certificate.(29)
4.45 Form of Warrant Certificate re: Existing Warrants.(30)
4.46 Form of Stock Purchase Warrant re: 97-D and 97-F Preferred Stock.(30)
4.47 Form of Stock Purchase Warrant re: Series 97-B Preferred Stock.(29)
4.48 Form of Stock Purchase Warrant re Series 97-G Preferred Stock.(29)
4.49 Series 97-D Preferred Stock Purchase Agreement dated August 12, 1997
between the Registrant and the holders thereof.(30)
4.50 Registration Rights Agreement re: Series 97-D Preferred Stock dated
August 12, 1997 between the Registrant and the holders thereof.(30)
4.51 Series 97-F 8% Convertible Preferred Stock Subscription Agreement
dated November 6, 1997 between the Registrant and the holders hereof.(30)
4.52 Registration Rights Agreement re: Series 97-F Preferred Stock dated
November 6, 1997 between the Registrant and the holders thereof.(30)
4.53 Series 97-G 8% Convertible Preferred Stock Subscription Agreement between
the Registrant and Settondown Capital dated January 8, 1998.(29)
4.54 Series 97-G 8% Convertible Preferred Stock Subscription Agreement between
Registrant and Dominion Capital dated January 8, 1998.(29)
4.55 Form of Registration Rights Agreement re: Series 97-G Preferred Stock
dated January 8, 1998 between the Registrant and the holders thereof.(29)
4.56 Agreement between the Registrant and AEM dated December 11, 1997.(29)
4.57 Agreement between the Registrant and The Taxin Network
dated April 22, 1997.(29)
4.58 Certificate of Secretary re: Designation of Series 98-A Preferred
Stock.(31)
4.59 Form of Series 98-A Stock Purchase Warrant(31)
4.60 Series 98-A 6% Convertible Preferred Stock Placement Agent Subscription
Agreement dated March 6, 1998, between Registrant and the holders thereof. (31)
4.61 Registration Rights Agreement for Placement Agent re: Series 98-A
Preferred Stock date March 6, 1998, between the Registrant and the
holders thereof. (31)
4.62 Series 98-A 6% Convertible Preferred Stock Subscription Agreement dated
March 6, 1998, between Registrant and the holders thereof. (31)
4.63 Registration Rights Agreement re: Series 98-A Preferred Stock date
March 6, 1998, between the Registrant and the holders thereof. (31)
10.1.1 Amended and Restated Agreements with LFC Technology
Partners - Pre 10/1/87(4)
10.1.2 Amended Technology Transfer Agreement dated 10/1/87(5)
10.1.3 Research Agreement Waiver (and Amended Research Notes) dated 10/1/87(5)
10.2 AEM Agreement(2)(3)
10.3.1 Assignment Agreement dated 11/13/84 with Ernest Esztergar(6)
10.3.2 First Amendment to Assignment Agreement dated 12/31/87 with Ernest
Esztergar(5)
10.4 Employment Agreement with Ernest Esztergar(2)(3)
10.4.1 Employment Agreement with Ernest Esztergar (1995)(26)
10.5 Lease for executive offices at 3366 N. Torrey Pines Ct. #220, La Jolla,
CA 92037(4)
10.5.1 Lease of executive offices (LJF)(14)
10.5.2 First amendment to Lease of Executive offices dated as of 10/17/95 (26)
10.6 Modification Agreement dated as of 10/1/87(7)
10.6.1 Settlement Agreement dated as of December 10, 1992(18)
10.7 Agreement to Proceed (including Agreement to Proceed, LFC Release and
Addendum)(5)
10.8 Participation Agreement (including Participation Agreement,
Confidentiality Agreement and Addendum)(5)
10.9 Agreement dated as of July 1, 1988 between AEM and Company(9)
10.10 Agreement dated July 19, 1989 between SMC and Company(10)
10.11 Technology Purchase Agreement, dated as of 9/28/89(11)
10.12 Partnership Agreement, dated as of 9/30/89(11)
10.12.1 First Amendment to Partnership Agreement dated as of 12/1/91(17)
10.12.2 Second Amendment to Partnership Agreement dated as of 5/1/95(26)
10.13 SGI Assignment Agreement, dated as of 9/30/89(11)
10.14 SMC Assignment Agreement, dated as of 9/30/89(11)
10.15 Coal Handling License, dated as of 9/30/89(11)
10.16 License to SGI International, dated as of 9/30/89(11)
10.17 License to Shell Mining Company, dated as of 9/30/89(11)
10.18.1 First Amendment to License to Shell Mining Company, dated as
of 5/01/95(26)
10.19 ENCOAL/SGI Services Agreement, dated as of 7/18/90(14)
10.20 SMC Services Agreement, dated as of 9/30/89(11)
10.21 Accounting Procedures(11)
10.22 Confidentiality Addendum(11)
10.23 Addendum to Documents 10.19 through 10.29(11)
10.24 Letter of Intent dated June 5, 1993 between Company & Shanxi Coal Bureau,
China(20)
10.25 Letter of Intent dated July 16, 1993 between Company & Fushun Coal Mine
Administration, China (20)
10.26 Letter of Intent dated January 28, 1994 between Company and Shandong
Provincial Coal Bureau, and Comprehensive Utilization Corporation of
Shandong Coal Industry, China(21)
10.27 Acquisition Agreement dated as of September 8, 1995(25)
10.28.1 Lending and Commitment Agreement dated as of September 8, 1995(25)
10.28.2 First Amendment to Acquisition and Funding Agreement dated as of
September 22, 1995(25)
10.28.3 Second Amendment to Acquisition & Funding Agreement dated as of
October 20, 1995 (24)
10.29 Technology Transfer Agreement (SGI/OCET) dated 3/17/95(26)
10.29.1 First Amendment to Technology Transfer Agreement dated as of 5/15/95(26)
10.29.2 Second Amendment to Technology Transfer Agreement dated as of
August 25, 1996 (28)
10.30 Employment Agreement with Joseph A. Savoca dated as of June 12, 1995 (26)
18.1 Letter re: Change in Accounting Principles(4)
22.1 Subsidiaries(5)
23.1 Consent of J.H. Cohn LLP, Independent Auditors (30)
23.2 Consent of Ernst & Young LLP, Independent Auditors (30)
99.1 Agreement dated June 20, 1988(8)
99.2 Modification Agreement dated August 1, 1988(8)
99.3 Colstrip Notes(8)
99.4.1 Other Notes (Healy Alaska)(8)
99.5 LTI Agreement(8)
99.6 SGI/MOP General Release(8)
99.7 Creditor Releases(8)
99.8 SGIF/DOE/METC Agreement dated 9/20/91(17)
(1) Incorporated by reference to the Registrant's
Registration Statement on Form S-14 (File No.
2-93124) (the "Registration Statement") filed on
September 6, 1984.
(2) Incorporated by reference to Amendment No. 2 to the Registration Statement
filed on April 24, 1985.
(3) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for the
year ended December 31, 1985.
(4) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for the
year ended December 31, 1986.
(5) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for the
year ended December 31, 1987.
(6) Incorporated by reference to Amendment No. 1 to the Registration Statement
filed on December 31, 1984.
(7) Incorporated by reference to Report on Form 10-Q (File No. 2-93124) for the
quarter ended September 30, 1987.
(8) Incorporated by reference to Report on Form 10-Q (File No. 2-93124) for the
quarter ended June 30, 1988.
(9) Incorporated by reference to Exhibit 10.18 (sic) in Report on Form 10-Q
(File No. 2-93124) for the fiscal quarter ended March 31,1990.
(10) Incorporated by reference to Exhibit 10.18 (sic) in Report on Form 10-Q
(File No. 2-93124) for the fiscal quarter ended September 30, 1990.
(11) Incorporated by reference to Report on Form 10-Q (File No. 2-93124) for
the quarter ended March 31, 1990.
(12) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the year ended December 31, 1988.
(13) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the year ended December 31, 1989.
(14) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the year ended December 31, 1990.
(15) Incorporated by reference to Exhibit 4 in Registration Statement on Form
S-8 (File No. 2-93124) filed on December 1990.
(16) Incorporated by reference to Exhibit 4 in Registration Statement on Form
S-8 (File No. 2-93124) filed on March 1, 1991.
(17) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the year ended December 31, 1991.
(18) Incorporated by reference to Report on Form 8-K (File No. 2-93124) filed
on January 15, 1993.
(19) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the l year ended December 31, 1992.
(20) Incorporated by reference to 1st Amendment to Form S-1 filed December
20, 1993.
(21) Incorporated by reference to 3rd Amendment to Form S-1 filed March 9, 1994.
(22) Incorporated by reference to Report on Form 10K (File No. 2-93124) for the
year ended December 31,1993.
(23) Incorporated by reference to Report on Form 10K (File No. 2-93124) for the
year ended December 31,1994.
(24) Incorporated by reference to Report on Form 10-Q (File No. 2-93124)for the
quarter ending September 30, 1995.
(25) Incorporated by reference to Report on Form 8-K/A (File No. 2-93124)
filed October 6, 1995.
(26) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the year ended December 31, 1995.
(27) Incorporated by reference to Report on Form 10-K (File No. 2-93124) for
the year ended December 31, 1996.
(28) Incorporated by reference to Exhibit 4 in Registration Statement on Form
S-8 (File No. 2-93124) filed on December 26, 1996.
(29) Incorporated by reference to Exhibit 4 in Registration Statement on Form
S-2 (File No. 2-93124) filed on January 23, 1998.
(30) Incorporated by reference to Report on Form 10-Q (File No. 2-93124) for
the quarter ending September 30, 1997.
(31) Filed herewith.



(b) Reports on Form 8-K filed in the fourth quarter of 1996: November 26, 1997,
Change in registrants Certifying Accountant; January 23, 1998, Sale of Equity
Securities pursuant to Reg S..
(c) Exhibits - The response to this portion of Item 14 is submitted as a
separate section of this report
(d) Not applicable





<PAGE>


SIGNATURES

Pursuant to requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized on this 31th day of March 1998.

SGI INTERNATIONAL


By: /s/
----------------------------------
Joseph A. Savoca, Chairman/CEO


Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.


SIGNATURE TITLE DATE


/s/ Chief Executive Officer March 31, 1998
------------------------------------
Joseph A. Savoca Director, Chief Financial Officer


/s/ Director March 31, 1998
------------------------------------
Bernard V. Baus


/s/ Director March 31, 1998
------------------------------------
Ernest P. Esztergar


/s/ Director March 31, 1998
------------------------------------
Norman Grant


/s/ Director March 31, 1998
------------------------------------
William Harris


/s/ Director March 31, 1998
------------------------------------
William A. Kerr


<PAGE>


INDEX TO EXHIBITS

Exhibit No. Title


4.58 Certificate of Secretary re: Designation of Series 98-A Preferred Stock.
4.59 Form of Series 98-A Stock Purchase Warrant.
4.60 Series 98-A 6% Convertible Preferred Stock Placement Agent Subscription
Agreement dated March 6, 1998, between Registrant and the holders thereof.
4.61 Registration Rights Agreement for Placement Agent re: Series 98-A
Preferred Stock date March 6, 1998, between the Registrant and the holders
thereof.
4.62 Series 98-A 6% Convertible Preferred Stock Subscription Agreement dated
March 6, 1998, between Registrant and the holders thereof.
4.63 Registration Rights Agreement re: Series 98-A Preferred Stock date
March 6, 1998, between the Registrant and the holders thereof.
23.1 Consent of J.H. Cohn LLP, Independent Auditors.
23.2 Consent of Ernst & Young LLP, Independent Auditors.