**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**





**WASHINGTON,
      DC 20549**





**FORM
      10-QSB**




þ
            
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
                ACT OF
                1934****FOR
                THE QUARTERLY PERIOD ENDED June 30,
                2007**




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




**For
      the transition period from to** **** **to** ****





**Commission
      File Number: 001-32228**





**O2DIESEL
      CORPORATION**


(Name
      of
      small business issuer in its charter)




Delaware
              (State
                or Other
              Jurisdiction
                of Incorporation)
            
            91-2023525
              (IRS
                Employer
              Identification
                No.)




100
      COMMERCE DRIVE, Suite 301


NEWARK,
      DELAWARE 19713


(Address
      of Principal Executive Offices)





(302) 266-6000


(Issuer's
      telephone number)





Not
      Applicable


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





Check
      whether the Issuer (1) filed all reports required to be filed by
      Section 13 or 15(d) of the


Securities
      Exchange Act during the past 12 months (or for such shorter period that the
      registrant was


required
      to file such reports), and (2) has been subject to such filing requirements
      for the past 90 days.


Yes þ No o





APPLICABLE
      ONLY TO CORPORATE ISSUERS





Indicated
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act).


Yes o No þ





APPLICABLE
      ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE
      YEARS:





Check
      whether the registrant filed all documents and reports required to be filed
      by
      Section 12, 13 or


15(d)
      of
      the Exchange Act after the distribution of securities under a plan confirmed
      by
      the court.


Yes o No o





State
      the
      number of shares outstanding of each of the issuer's classes of
      common


equity,
      as of the latest practicable date:





As
      of
      August 6, 2007, the registrant had 83,315,341 shares of Common
      Stock,


$0.0001
      par value per share, issued and outstanding





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









O2DIESEL
      CORPORATION


FOR
      THE
      QUARTER ENDED June 30, 2007


INDEX
      TO
      FORM 10-QSB


PART
      I
      FINANCIAL INFORMATION





Item 1.
                Financial Statements
            
            
            F-1Item 2.
                Management's Discussion and Analysis or Plan of Operation
            
            
            1Item 3.
                Controls and Procedures
            
            
            10PART
                IIItem 1.
                Legal Proceedings
            
            
            11Item 2.
                Unregistered Sales of Equity Securities and Use of
                Proceeds
            
            
            11Item 3.
                Defaults Upon Senior Securities
            
            
            11Item 4.
                Submission of Matters to a Vote of Security Holders
            
            
            11Item 5.
                Other Information
            
            
            11Item 6.
                Exhibits
            
            
            12Signatures
            
            
            12




NOTE
      REGARDING FORWARD LOOKING STATEMENTS





This
      quarterly report on Form 10-QSB contains forward-looking statements concerning
      O2Diesel Corporation (“O2Diesel,” the “Company” or the “Registrant”) and its
      future operations, plans and other matters. Any statements that involve
      discussions with respect to predictions, expectations, beliefs, plans,
      projections, objectives, assumptions or future events or performance (often,
      but
      not always, using phrases such as “expects”, or “does not expect”, “is
      expected”, “anticipates” or “does not anticipate”, “plans”, “estimates” or
“intends”, or stating that certain actions, events or results “may”, “could”,
“might”, or “will” be taken or occur or be achieved) are not statements of
      historical fact and may be “forward looking statements” which include statements
      relating to, among other things, the ability of O2Diesel to successfully compete
      in the fuel additive and fuel distribution business.





O2Diesel
      cautions readers not to place undue reliance on any such forward-looking
      statements, which speak only as of the date made. Such forward-looking
      statements are based on the beliefs of O2Diesel's management as well as on
      assumptions made by and information currently available to O2Diesel at the
      time
      such statements were made. Forward-looking statements are subject to a variety
      of risks and uncertainties which could cause actual events or results to differ
      from those reflected in the forward-looking statements, including, without
      limitation, the failure to obtain adequate financing on a timely basis and
      other
      risks and uncertainties. Actual results could differ materially from those
      projected in the forward-looking statements, as a result of either the matters
      set forth or incorporated in this report generally or certain economic and
      business factors, some of which may be beyond the control of O2Diesel. These
      factors include adverse economic conditions, entry of new and stronger
      competitors, inadequate capital, unexpected costs, failure to gain product
      approval in the United States or foreign countries for the commercialization
      and
      distribution of our products, failure to capitalize upon access to new markets
      and failure in obtaining the quality and quantity of ethanol necessary to
      produce our product at competitive prices. O2Diesel disclaims any obligation
      subsequently to revise any forward-looking statements to reflect events or
      circumstances after the date of such statements or to reflect the occurrence
      of
      anticipated or unanticipated events.







O2Diesel
      Corporation


(A
      Development Stage Company)





FINANCIAL
      INFORMATION


ITEM
      1.




**Consolidated
      Balance Sheet**


**June
      30, 2007**


**ASSETS****CURRENT
                  ASSETS**Cash
              
              $
              460,237Restricted
                  cash
              
              
              3,141,733Accounts
                  receivable
              
              
              106,487Due
                  from related parties
              
              
              37,760Other
                  receivables
              
              
              1,185,314Unbilled
                  appropriations receivable
              
              
              81,829Inventory
              
              
              89,231Prepaid
                  expenses, parts and deposits
              
              
              285,576Total
                  current assets
              
              
              5,388,167**FURNITURE
                  AND EQUIPMENT**Office
                  furniture and equipment
              
              
              216,208Fuel
                  and test equipment
              
              
              213,350429,558Less
                  accumulated depreciation
              
              
              (232,891
              )196,667**TOTAL
                  ASSETS**
              
              ***$***
              ***5,584,834*****LIABILITIES
                  AND STOCKHOLDERS' EQUITY****CURRENT
                  LIABILITIES**Accounts
                  payable
              
              $
              1,140,658Accrued
                  expenses
              
              
              288,924Due
                  to related parties
              
              
              188,020Deferred
                  grants
              
              
              343,599Deferred
                  marketing program
              
              
              98,000Other
                  current liabilities
              
              
              8,190Total
                  current liabilities
              
              
              2,067,391**TOTAL
                  LIABILITIES**
              
              
              **2,067,391****STOCKHOLDERS'
                  EQUITY**Preferred
                  stock: par value of $0.0001; 20,000,000 shares authorized;none
                  issued and outstanding
              
              
              -Common
                  stock: par value of $0.0001; 135,000,000 shares
                  authorized;76,680,055
                  issued and outstanding
              
              
              7,668Additional
                  paid-in capital
              
              
              41,133,246Unearned
                  compensation
              
              
              (57,337
              )Accumulated
                  other comprehensive income
              
              
              5,431Deficit
                  accumulated during the development stage
              
              
              (37,571,565
              )Total
                  stockholders' equity
              
              
              3,517,443**TOTAL
                  LIABILITIES AND STOCKHOLDERS' EQUITY**
              
              ***$***
              ***5,584,834***




See
      Notes
      to Financial Statements




F-1




**02Diesel
      Corporation**


**(A
      Development Stage Company)**


**Consolidated
      Statements of Operations**


October
                    14, 2000(inception)Six
                    months ended June 30,
                
                Three
                    months ended June 30,
                
                through2007
                
                2006
                
                2007
                
                2006
                
                June
                    30, 2007**Revenue:**Additive
                    related sales
                
                $
                180,998
                
                $
                68,500
                
                $
                15,035
                
                $
                30,375
                
                $
                619,321Sponsorship
                    income
                
                
                19,500
                
                
                36,996
                
                
                3,750
                
                
                24,249
                
                
                167,373**Total
                      revenue**
                
                
                200,498
                
                
                105,496
                
                
                18,785
                
                
                54,624
                
                
                786,694**Operating
                    expenses:**Cost
                    of goods sold
                
                
                145,511
                
                
                54,342
                
                
                14,130
                
                
                26,257
                
                
                471,818Selling
                    and marketing
                
                
                705,638
                
                
                561,328
                
                
                379,429
                
                
                316,478
                
                
                8,552,492Product
                    testing and government grants, net
                
                
                189,665
                
                
                159,775
                
                
                26,550
                
                
                122,438
                
                
                1,167,448General
                    and administrative
                
                
                3,749,145
                
                
                3,147,711
                
                
                1,715,870
                
                
                1,621,498
                
                
                29,298,175**Total
                    operating expenses**
                
                
                4,789,959
                
                
                3,923,156
                
                
                2,135,979
                
                
                2,086,671
                
                
                39,489,933**Operating
                    loss**
                
                
                **(4,589,461**
                **)**
                
                **(3,817,660**
                **)**
                
                **(2,117,194**
                **)**
                
                **(2,032,047**
                **)**
                
                **(38,703,239**
                **)****Other
                    income (expense):**Interest
                    expense
                
                
                (4,906
                )
                
                (4,092
                )
                
                (3,053
                )
                
                (2,447
                )
                
                (127,429
                )Interest
                    income
                
                
                28,094
                
                
                41,431
                
                
                5,704
                
                
                38,254
                
                
                223,460Foreign
                    currency gain/(loss), net
                
                
                81,538
                
                
                280,457
                
                
                34,232
                
                
                210,865
                
                
                580,321Other
                    (expense)/income, net
                
                
                (390
                )
                
                (3,528
                )
                
                (280
                )
                
                (231
                )
                
                309,680**Total
                    other income (expense)**
                
                
                104,336
                
                
                314,268
                
                
                36,603
                
                
                246,441
                
                
                986,032**Loss
                    before benefit for income taxes**
                
                
                (4,485,125
                )
                
                (3,503,392
                )
                
                (2,080,591
                )
                
                (1,785,606
                )
                
                (37,717,207
                )Benefit
                    for income taxes
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                145,642**Net
                    loss**
                
                
                **(4,485,125**
                **)**
                
                **(3,503,392**
                **)**
                
                **(2,080,591**
                **)**
                
                **(1,785,606**
                **)**
                
                **(37,571,565**
                **)****Deemed
                    dividend to preferred stockholders**
                
                
                **-**
                
                
                **(5,581,133**
                **)**
                
                **-**
                
                
                **(2,255,934**
                **)**
                
                **(6,200,005**
                **)****Net
                    loss allocable to common stockholders**
                
                **$**
                **(4,485,125**
                **)**
                **$**
                **(9,084,525**
                **)**
                **$**
                **(2,080,591**
                **)**
                **$**
                **(4,041,540**
                **)**
                **$**
                **(43,771,570**
                **)**Net
                    loss per common share(basic
                    and diluted)
                
                $
                (0.06
                )
                $
                (0.16
                )
                $
                (0.03
                )
                $
                (0.06
                )
                $
                (1.07
                )Weighted
                    average shares of commonshares
                    outstanding
                
                
                75,504,260
                
                
                57,335,896
                
                
                75,642,046
                
                
                67,759,855
                
                
                60,639,496Recapitalization
                    resulting from the AAETechnologies
                    International PLC acquisition
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (19,631,862
                )Weighted
                    average shares of commonshares
                    outstanding - giving effect to therecapitalization
                
                
                75,504,260
                
                
                57,335,896
                
                
                75,642,046
                
                
                67,759,855
                
                
                41,007,634


See
      Notes
      to Financial Statements




F-2




O2Diesel
      Corporation


(A
      Development Stage Company)


**Consolidated
      Statement of Changes in Stockholders' Equity (Deficit)**


**October 14,
      2000 (Inception) through June 30, 2007**




Common
              
              AdditionalPreferred
                  Stock
              
              Common
                  Stock
              
              Unearned
              
              Stock
              
              Paid
                  - InShares
              
              Amount
              
              Shares
              
              Amount
              
              Compensation
              
              Subscribed
              
              CapitalBalance
                  at October 14, 2000 (Inception)Common
                  stock issued in exchange for interest in wholly owned
                  subsidiaries
              
              
              -
              
              $
              -
              
              
              43,008,772
              
              $
              430,088
              
              $
              -
              
              $
              -
              
              $
              3,603,415Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued on various dates during 2001
              
              
              -
              
              
              -
              
              
              24,181,038
              
              
              241,810
              
              
              -
              
              
              -
              
              
              1,268,031Balance
                  at December 31, 2001
              
              
              -
              
              
              -
              
              
              67,189,810
              
              
              671,898
              
              
              -
              
              
              -
              
              
              4,871,446Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued at $0.225 per share on various dates during
                  2002
              
              
              -
              
              
              -
              
              
              703,282
              
              
              7,033
              
              
              -
              
              
              -
              
              
              515,657Balance
                  at December 31, 2002
              
              
              -
              
              
              -
              
              
              67,893,092
              
              
              678,931
              
              
              -
              
              
              -
              
              
              5,387,103Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued on various dates during 2003
              
              
              -
              
              
              -
              
              
              555,556
              
              
              5,556
              
              
              -
              
              
              -
              
              
              119,444Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              200,000
              
              
              2,000
              
              
              -
              
              
              -
              
              
              43,000Common
                  stock issued for remaining interest in subsidiaries on July 15,
                  2003
              
              
              -
              
              
              -
              
              
              4,356,200
              
              
              43,562
              
              
              -
              
              
              -
              
              
              46,323Common
                  stock issued upon exercise of stock options on various dates during
                  2003
              
              
              -
              
              
              -
              
              
              8,670,881
              
              
              86,709
              
              
              -
              
              
              -
              
              
              1,131,595Recapitalization
                  resulting from AAE acquisition on July 15, 2003
              
              
              -
              
              
              -
              
              
              (56,928,690
              )
              
              (814,283
              )
              
              -
              
              
              -
              
              
              814,283Common
                  stock issued at $1.50 per share on various dates during
                  2003
              
              
              -
              
              
              -
              
              
              3,333,333
              
              
              333
              
              
              -
              
              
              -
              
              
              4,999,667Expenses
                  related to 2003 issuance of common stock and
                  recapitalization
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (795,650
              )Subscriptions
                  for 754,900 shares of common stock at $1.50 per share on various
                  dates
                  during 2003
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,132,350
              
              
              -Balance
                  at December 31, 2003
              
              
              -
              
              
              -
              
              
              28,080,372
              
              
              2,808
              
              
              -
              
              
              1,132,350
              
              
              11,745,765Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued at $1.50 per share on various dates in 2004
              
              
              -
              
              
              -
              
              
              1,070,451
              
              
              107
              
              
              -
              
              
              (1,132,350
              )
              
              1,535,770Preferred
                  stock issued on various dates during 2004
              
              
              1,550,000
              
              
              155
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              5,478,609Balance
                  at December 31, 2004
              
              
              1,550,000
              
              
              155
              
              
              29,150,823
              
              
              2,915
              
              
              -
              
              
              -
              
              
              18,760,144Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              63,750
              
              
              6
              
              
              -
              
              
              -
              
              
              63,094Warrants
                  issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              135,000Common
                  stock issued at $0.70 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              7,515,981
              
              
              752
              
              
              -
              
              
              -
              
              
              4,832,439Common
                  stock issued at $0.7125 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              3,228,070
              
              
              322
              
              
              -
              
              
              -
              
              
              2,090,178Common
                  stock issued at $0.564 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              6,419,840
              
              
              642
              
              
              -
              
              
              -
              
              
              3,599,658Balance
                  at December 31, 2005
              
              
              1,550,000
              
              
              155
              
              
              46,378,464
              
              
              4,637
              
              
              -
              
              
              -
              
              
              29,480,513Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued via exercise of warrants on various dates in
                  2006
              
              
              -
              
              
              -
              
              
              3,151,892
              
              
              315
              
              
              -
              
              
              -
              
              
              1,457,829Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              56,250
              
              
              6
              
              
              -
              
              
              -
              
              
              50,994Conversion
                  of preferred stock into common stock on various dates in
                  2006
              
              
              (1,550,000
              )
              
              (155
              )
              
              15,500,000
              
              
              1,550
              
              
              -
              
              
              -
              
              
              (1,395
              )Common
                  stock issued at $0.75 per share in 2006
              
              
              -
              
              
              -
              
              
              8,666,666
              
              
              867
              
              
              -
              
              
              -
              
              
              6,256,282Common
                  stock issued at $0.729 per share in 2006
              
              
              -
              
              
              -
              
              
              1,371,742
              
              
              138
              
              
              -
              
              
              -
              
              
              979,367Fair
                  value of unvested stock options upon adoption of SFAS 123R
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (376,031
              )
              
              -
              
              
              376,031Amortization
                  of unearned compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              250,890
              
              
              -
              
              
              -Fair
                  value of stock options issued in 2006
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,476,684Balance
                  at December 31, 2006
              
              
              -
              
              
              -
              
              
              75,125,014
              
              
              7,513
              
              
              (125,141
              )
              
              -
              
              
              40,076,305Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Foreign
                  currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued to employee
              
              
              -
              
              
              -
              
              
              166,667
              
              
              17
              
              
              -
              
              
              -
              
              
              136,633Fair
                  value of unearned shares related to commitment shares
              
              
              -
              
              
              -
              
              
              805,987
              
              
              80
              
              
              -
              
              
              -
              
              
              668,889Unearned
                  common stock issued for commitment shares
              
              
              -
              
              
              -
              
              
              (658,607
              )
              
              (66
              )
              
              -
              
              
              -
              
              
              (546,577
              )Fusion
                  shares issued at various prices in 2007
              
              
              -
              
              
              -
              
              
              970,994
              
              
              97
              
              
              -
              
              
              -
              
              
              499,903Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              270,000
              
              
              27
              
              
              -
              
              
              -
              
              
              143,573Amortization
                  of unearned compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              67,804
              
              
              -
              
              
              -Fair
                  value of stock options issued in 2006
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              154,520Balance
                  at June 30, 2007
              
              
              -
              
              $
              -
              
              
              76,680,055
              
              $
              7,668
              
              $
              (57,337
              )
              $
              -
              
              $
              41,133,246




See
      Notes
      to Financial Statements




F-3




O2Diesel
      Corporation


(A
      Development Stage Company)


**Consolidated
      Statement of Changes in Stockholders' Equity (Deficit)**


**October 14,
      2000 (Inception) through June 30, 2007**


DeficitCommon
              
              Accumulated
              
              Accumulated
              
              TotalStock
              
              Other
              
              During
                  the
              
              Stockholders'Subscriptions
              
              Comprehensive
              
              Development
              
              EquityReceivable
              
              Income
                  (Loss)
              
              Stage
              
              (Deficit)Balance
                  at October 14, 2000 (Inception)Common
                  stock issued in exchange for interest in wholly owned
                  subsidiaries
              
              $
              -
              
              $
              -
              
              $
              (4,138,684
              )
              $
              (105,181
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              (1,406,709
              )
              
              (1,406,709
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (4,476
              )
              
              -
              
              
              (4,476
              )Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,411,185
              )Common
                  stock issued on various dates during 2001
              
              
              -
              
              
              -
              
              
              -
              
              
              1,509,841Balance
                  at December 31, 2001
              
              
              -
              
              
              (4,476
              )
              
              (5,545,393
              )
              
              (6,525
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              (1,712,803
              )
              
              (1,712,803
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (74,085
              )
              
              -
              
              
              (74,085
              )Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,786,888
              )Common
                  stock issued at $0.225 per share on various dates during
                  2002
              
              
              -
              
              
              -
              
              
              -
              
              
              522,690Balance
                  at December 31, 2002
              
              
              -
              
              
              (78,561
              )
              
              (7,258,196
              )
              
              (1,270,723
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              (4,230,296
              )
              
              (4,230,296
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              179,689
              
              
              -
              
              
              179,689Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (4,050,607
              )Common
                  stock issued on various dates during 2003
              
              
              -
              
              
              -
              
              
              -
              
              
              125,000Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              45,000Common
                  stock issued for remaining interest in subsidiaries on July 15,
                  2003
              
              
              -
              
              
              -
              
              
              (409,614
              )
              
              (319,729
              )Common
                  stock issued upon exercise of stock options on various dates during
                  2003
              
              
              -
              
              
              -
              
              
              -
              
              
              1,218,304-Recapitalization
                  resulting from AAE acquisition on July 15, 2003
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued at $1.50 per share on various dates during
                  2003
              
              
              -
              
              
              -
              
              
              -
              
              
              5,000,000Expenses
                  related to 2003 issuance of common stock and
                  recapitalization
              
              
              -
              
              
              -
              
              
              -
              
              
              (795,650
              )Subscriptions
                  for 754,900 shares of common stock at $1.50 per share on various
                  dates
                  during 2003
              
              
              (180,000
              )
              
              -
              
              
              -
              
              
              952,350Balance
                  at December 31, 2003
              
              
              (180,000
              )
              
              101,128
              
              
              (11,898,106
              )
              
              903,945Net
                  loss
              
              
              -
              
              
              -
              
              
              (6,728,014
              )
              
              (6,728,014
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (97,446
              )
              
              -
              
              
              (97,446
              )Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (6,825,460
              )Common
                  stock issued at $1.50 per share on various dates in 2004
              
              
              180,000
              
              
              -
              
              
              -
              
              
              583,527Preferred
                  stock issued on various dates during 2004
              
              
              -
              
              
              -
              
              
              -
              
              
              5,478,764Balance
                  at December 31, 2004
              
              
              -
              
              
              3,682
              
              
              (18,626,120
              )
              
              140,776Net
                  loss
              
              
              -
              
              
              -
              
              
              (6,852,165
              )
              
              (6,852,165
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              2,329
              
              
              -
              
              
              2,329Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (6,849,836
              )Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              63,100Warrants
                  issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              135,000Common
                  stock issued at $0.70 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              4,833,191Common
                  stock issued at $0.7125 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              2,090,500Common
                  stock issued at $0.564 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              3,600,300Balance
                  at December 31, 2005
              
              
              -
              
              
              6,011
              
              
              (25,478,285
              )
              
              4,013,031Net
                  loss
              
              
              -
              
              
              -
              
              
              (7,608,155
              )
              
              (7,608,155
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (10,392
              )
              
              -
              
              
              (10,392
              )Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (7,618,547
              )Common
                  stock issued via exercise of warrants on various dates in
                  2006
              
              
              -
              
              
              -
              
              
              -
              
              
              1,458,144Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              51,000Conversion
                  of preferred stock into common stock on various dates in
                  2006
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued at $0.75 per share in 2006
              
              
              -
              
              
              -
              
              
              -
              
              
              6,257,149Common
                  stock issued at $0.729 per share in 2006
              
              
              -
              
              
              -
              
              
              -
              
              
              979,505Fair
                  value of unvested stock options upon adoption of SFAS 123R
              
              
              -
              
              
              -
              
              
              -
              
              
              -Amortization
                  of unearned compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              250,890Fair
                  value of stock options issued in 2006
              
              
              -
              
              
              -
              
              
              -
              
              
              1,476,684Balance
                  at December 31, 2006
              
              
              -
              
              
              (4,381
              )
              
              (33,086,440
              )
              
              6,867,856Net
                  loss
              
              
              -
              
              
              -
              
              
              (4,485,125
              )
              
              (4,485,125
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              9,812
              
              
              -
              
              
              9,812Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (4,475,313
              )Common
                  stock issued to employee
              
              
              -
              
              
              -
              
              
              -
              
              
              136,650Fair
                  value of unearned shares related to commitment shares
              
              
              -
              
              
              -
              
              
              -
              
              
              668,969Unearned
                  common stock issued for commitment shares
              
              
              -
              
              
              -
              
              
              -
              
              
              (546,643
              )Fusion
                  shares issued at various prices in 2007
              
              
              -
              
              
              -
              
              
              -
              
              
              500,000Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              143,600Amortization
                  of unearned compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              67,804Fair
                  value of stock options issued in 2006
              
              
              -
              
              
              -
              
              
              -
              
              
              154,520Balance
                  at June 30, 2007
              
              $
              -
              
              $
              5,431
              
              $
              (37,571,565
              )
              $
              3,517,443




See
      Notes
      to Financial Statements




F-4




O2Diesel
      Corporation


(A
      Development Stage Company)


**Consolidated
      Statements of Cash Flows**


October
                  14, 2000Six
                  Months Ended June 30,
              
              (inception)
                  through2007
              
              2006
              
              June
                  30, 2007**Cash
                  flows from operating activites****Net
                  loss**
              
              **$**
              **(4,485,125**
              **)**
              **$**
              **(3,503,392**
              **)**
              **$**
              **(37,571,565**
              **)**Adjustments
                  to reconcile loss to net cash used in operating activites:Depreciation
              
              
              44,015
              
              
              41,696
              
              
              327,779Amortization
              
              
              -
              
              
              -
              
              
              7,786Write
                  off of patent
              
              
              -
              
              
              -
              
              
              337,329Write
                  off of obsolete inventory
              
              
              -
              
              
              -
              
              
              5,925Loss(Gain)
                  on sale/disposal of furniture & equipment
              
              
              -
              
              
              7,364
              
              
              8,528Non
                  cash contributions
              
              
              -
              
              
              1,564
              
              
              5,312Common
                  stock and warrants issued for consulting services
              
              
              143,600
              
              
              35,437
              
              
              397,700Common
                  stock issued to employee
              
              
              136,650
              
              
              -
              
              
              136,650Common
                  stock issued for commitment shares
              
              
              122,326
              
              
              -
              
              
              122,326Amortization
                  of unearned compensation
              
              
              222,324
              
              
              175,623
              
              
              1,949,898Changes
                  in operating assets and liabilites:Accounts
                  receivable
              
              
              (92,712
              )
              
              6,750
              
              
              (106,487
              )Due
                  from/(to) related parties
              
              
              45,139
              
              
              18,902
              
              
              150,260Other
                  receivables
              
              
              (452,727
              )
              
              (283,589
              )
              
              (1,185,314
              )Inventory,
                  prepaid expenses and other current assets
              
              
              17,315
              
              
              (209,569
              )
              
              (462,561
              )Accounts
                  payable
              
              
              590,766
              
              
              250,121
              
              
              1,140,658Accrued
                  expenses
              
              
              (97,743
              )
              
              (11,780
              )
              
              288,924Deferred
                  grants
              
              
              333,640
              
              
              355,434
              
              
              343,599Deferred
                  marketing program
              
              
              (136,500
              )
              
              (133,700
              )
              
              98,000Other
                  current liabilities
              
              
              1,628
              
              
              1,573
              
              
              (2,968
              )**Cash
                  flows used in operating activities**
              
              
              **(3,607,404**
              **)**
              
              **(3,247,566**
              **)**
              
              **(34,008,221**
              **)****Cash
                  flows from investing activities**Restricted
                  cash
              
              
              502,694
              
              
              (276,743
              )
              
              (3,141,733
              )Purchase
                  of furniture and equipment
              
              
              (10,495
              )
              
              (60,774
              )
              
              (539,376
              )Proceeds
                  from sale of furniture & equipment
              
              
              -
              
              
              600
              
              
              13,150Purchase
                  of patent
              
              
              -
              
              
              -
              
              
              (345,115
              )**Cash
                  flows provided by (used in) investing activities**
              
              
              **492,199**
              
              
              **(336,917**
              **)**
              
              **(4,013,074**
              **)****Cash
                  flows from financing activities**Net
                  proceeds from issuance of preferred stock
              
              
              -
              
              
              -
              
              
              5,478,764Net
                  proceeds from private placement
              
              
              -
              
              
              -
              
              
              5,953,757Net
                  proceeds from issuance of common stock
              
              
              500,000
              
              
              7,715,293
              
              
              27,050,493**Cash
                  flows provided by financing activities**
              
              
              **500,000**
              
              
              **7,715,293**
              
              
              **38,483,014**Effect
                  of exchange rate changes on cash
              
              
              9,812
              
              
              (2,101
              )
              
              (1,482
              )**Net
                  (decrease)/increase in cash**
              
              
              **(2,605,393**
              **)**
              
              **4,128,709**
              
              
              **460,237****Cash
                  at beginning of period**
              
              
              **3,065,630**
              
              
              **1,412,851**
              
              
              **-****Cash
                  at end of period**
              
              **$**
              **460,237**
              
              **$**
              **5,541,560**
              
              **$**
              **460,237**Cash
                  paid for interest
              
              $
              4,906
              
              $
              4,092
              
              $
              118,077Cash
                  paid for income taxes
              
              
              None
              
              
              None
              
              
              None
  Non-Cash
          Transactions: Conversion of bridge loan to common stock at
          9/30/2003 - $2,322,500.Conversion of preferred to common stock at various
          dates during 2006 - $1,550,000.


See
      Notes
      to Financial Statements




F-5




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**1.
      The Company and Basis of Presentation**





**The
      Company**





O2Diesel
      Corporation (“O2Diesel” or the “Company”) is in the development stage and has
      developed a proprietary additive product designed to enable distillate liquid
      transportation fuels to burn cleaner by facilitating the addition of ethanol
      as
      an oxygenate to these fuels. To date, the Company's operations have continued
      to
      be focused on raising capital, performing research and development, and bringing
      its product to market.





O2Diesel
      Corporation's predecessor, Dynamic Ventures, Inc., was incorporated in the
      State
      of Washington on April 24, 2000. Dynamic Ventures, Inc. changed its name to
      O2Diesel Corporation effective June 10, 2003, in contemplation of the
      reverse acquisition of AAE Technologies International Plc (“AAE”). On
      July 15, 2003, O2Diesel Corporation acquired all of the issued and
      outstanding shares of AAE in exchange for 17,847,039 shares of its common stock.
      As a result of this transaction, the former shareholders of AAE acquired control
      of the combined companies. The acquisition of AAE has been accounted for as
      a
      capital transaction followed by a recapitalization. AAE was considered to be
      the
      accounting acquirer. Accordingly, the historical financial statements of AAE
      are
      considered to be those of O2Diesel Corporation for all periods
      presented.





In
      conjunction with the reverse acquisition, the Company completed a private
      placement of its common stock whereby it issued 3,333,333 shares of common
      stock
      at $1.50 per share. Of the $5.0 million raised, approximately $800,000 was
      used
      to pay the costs of the reverse acquisition and private placement,
      $1.0 million was used to repay a bridge loan that was made in contemplation
      of the transaction, and the balance of $3.2 million was used to fund the
      ongoing developmental activities of the Company. Subsequent to its first private
      placement, the Company undertook to raise an additional $3.5 million
      through a follow-on private placement of our common stock (the “Follow-On
      Private Placement”). In the Follow-On Private Placement, we raised $1,535,770,
      before expenses, and issued 1,025,784 shares of our common stock at a price
      of
      $1.50 per share.





O2Diesel
      was reincorporated in the state of Delaware in a transaction that became
      effective on December 31, 2004.





On
      June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
      an application to list 46,518,898 shares of our common stock under the symbol
      OTD. As of August 6, 2007, the Exchange has approved additional applications
      to
      list 68,378,483 shares of the Company's common stock so that the total number
      of
      shares approved for listing is now 114,897,381. Our shares began to trade on
      the
      Exchange on July 1, 2004.





**Basis
      of Presentation**





The
      Company's unaudited consolidated financial statements, for the three and six
      months ended June 30, 2007, have been prepared on a going concern basis, which
      contemplates the realization of assets and the settlement of liabilities and
      commitments in the normal course of business. At June 30, 2007, the Company
      had
      working capital of $3,320,776 and had accumulated losses of $37,571,565. However,
      $3,141,733 of the working capital is restricted in use to operational costs
      associated with developing markets in Europe, and $735,000 of the working
      capital is a receivable from ProEco Energy Company. These factors, as well
      as
      the uncertain conditions that the Company faces regarding its AMEX listing
      status, create an uncertainty about the Company’s ability to continue as a going
      concern. Management of the Company is developing a plan to bring the Company
      into compliance with AMEX standards, and to commence profitable operations.
      The
      financial statements do not include any adjustments that might be necessary
      if
      the Company is unable to continue as a going concern.





The
      Company was notified in December 2004 by the AMEX that it was not in
      compliance with the listing standards of the Exchange because it lacked the
      requisite amount of stockholders' equity. AMEX requires that minimum levels
      of
      stockholders' equity be maintained. O2Diesel was not in compliance because
      its
      stockholders' equity had dropped below the required minimums, and it had
      experienced continuing losses for the past four years. In order to return to
      full compliance, O2Diesel needed to have stockholders' equity of
      $6.0 million by June 2006 and to maintain this level going
      forward.





In
      accordance with the procedures of the Exchange, we filed a plan (“Plan”) with it
      to demonstrate the steps we would take to return to full compliance. On
      February 15, 2005, the AMEX notified us that it had accepted our Plan, and
      that we would be given until June 2006 in which to regain compliance with
      the Exchange's listing rules. To achieve that level of stockholders' equity,
      we
      anticipated having to raise a total of approximately $10.0 million in new
      equity during 2005. In December 2005, the Company determined that it could
      not meet certain conditions of the Plan and met with representatives of the
      AMEX
      to discuss the need to develop an amended plan to demonstrate how the Company
      would be in compliance by June 2006.





The
      Company believed it needed to raise an additional $7.0 million in new
      capital prior to June 2006 to allow it to return to full compliance with
      the listing standards of the AMEX. In addition, the Company believed it needed
      to raise an additional $3.5 million in equity in the second half of 2006 to
      allow it to execute its business plan for the year and to remain in compliance
      with the AMEX standards.





The
      Company collected $592,692 (after expenses)
      and $865,452 (net of expenses) in two warrant exercises and closed three private
      placements totaling $7.5 million as part of this effort in 2006.




F-6





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company had regained compliance with AMEX listing requirements. At December
      31,
      2006, the Company was in compliance with AMEX listing requirements, but, for
      the
      period ended March 31, 2007, the Company was not able to meet the listing
      requirements. On June 29, 2007, the Company was notified by AMEX that it was
      not
      in compliance with the listing standards of the Exchange because it lacked
      the
      requisite amount of stockholders' equity. The Company was asked to submit a
      plan
      by July 27, 2007 advising AMEX of actions the Company would be taking to bring
      it into compliance with the continued listing standards by December 29, 2008.





On
      July
      27, 2007, the Company filed a plan with the Exchange describing the steps it
      plans to take to return to full compliance. As we describe later in this
      section, the Company has entered into a common stock purchase agreement to
      raise
      up to $10 million in new equity in 2007. Also, the Company announced a private
      placement in which we raised an additional $2.52 million, which is described
      under “Subsequent Events”. The Company intends to raise up to an additional $80
      million in new equity in conjunction with the acquisition of ProEco Energy.
      We
      believe these actions will enable us to meet or exceed the equity requirements
      of the Exchange.





If
      the
      Company were to fail to return to full compliance with the Exchange's listing
      standards, the AMEX would likely initiate procedures to de-list the Company's
      common stock. If the Company's common stock were to be de-listed by the AMEX,
      its shares would continue to be traded as a bulletin board stock.





The
      consolidated financial statements in this report do not include any adjustments
      to reflect the anticipated private placements or the possible future effects
      on
      the recoverability and classification of assets or the amounts and
      classification of liabilities that may result should management be unsuccessful
      in obtaining financing on terms acceptable to the Company.





Since
      July 2003, the Company has raised approximately $33 million for its
      operations.





**Transactions
      During the First Half of 2007**




**ProEco
      Transaction**





On
      January 12, 2007, the Company entered into a share exchange agreement (the
      “Share Exchange Agreement”) with ProEco Energy Company (“ProEco”) and its
      stockholders (“ProEco Stockholders”) to acquire shares equal to 80% of the
      outstanding capital stock of ProEco in exchange for approximately 9.2 million
      shares of the Company's common stock (the “Transaction Shares”) valued at $0.872
      per share for a total purchase price of $8.0 million.





ProEco,
      which has had limited operations to date, is in the process of developing a
      new
      proposed fuel-grade ethanol plant (the “Ethanol Plant”) with planned capacity of
      100 million gallons per year to be built in two 50 million gallon trains (each
      a
“Train”). ProEco Shareholders will receive 60% of the Transaction Shares at the
      time of the closing and will receive the remaining 40% of the Transaction Shares
      in two equal installments upon the completion of construction of the first
      Train
      (20%) and the commencement of construction of the final Train (20%). The
      remaining 40% of the Transaction Shares will be held in escrow until the
      conditions for their release have been met. The parties intend the transaction
      to qualify as a tax-free reorganization under Section 368(a) of the U.S.
      Internal Revenue Code of 1986, as amended.





The
      Share
      Exchange Agreement requires ProEco to complete a number of steps toward
      completion of the Ethanol Plant project in order for the closing of the share
      exchange to occur. At the time of the closing, ProEco must have entered into
      a
      definitive engineering, procurement and construction (“EPC”) contract with a
      reputable firm with extensive experience in implementing and completing projects
      similar to the Ethanol Plant project and executed marketing agreements for
      the
      sale of the production of the Ethanol Plant. Under the terms of the Share
      Exchange Agreement, ProEco is responsible for having the Ethanol Plant
      designated as a facility nameplated, or certified, as producing ethanol at
      a
      level of at least 100 million gallons of production a year.





As
      a
      condition to the closing of the ProEco share exchange, the Company is obligated
      to secure the financing necessary to complete the construction costs to build
      the Ethanol Plant. Accordingly, the Company will be required to raise $120
      to
      $140 million in debt and between $60 and $80 million in equity in two tranches
      in 2007.





Prior
      to
      closing, the Company and the ProEco Shareholders will enter into a shareholder
      agreement that will, among other things, impose restrictions on the transfer
      of
      the Transaction Shares.





The
      Common Stock will be issued to the ProEco shareholders in a transaction that
      will be exempt from the registration requirement pursuant to Section 4(2) of
      the
      Securities Act of 1933, as amended (the “Securities Act”) and under Regulation D
      promulgated under the Securities Act.




Under
      the
      terms of the letter of intent for the Share Exchange Agreement, the Company
      agreed to enter into a secured loan agreement with ProEco for the purposes
      of
      financing the purchase options for the land to be used for the Ethanol Plant
      and
      certain engineering and permitting work required for the closing of the ProEco
      share exchange. The annual interest rate on the loan is 7% and the maturity
      date of the loan is September 15, 2007. As of June 30, 2007, the Company had
      advanced $735,000 to ProEco under the terms of this agreement.




F-7




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements


**$10
      million Private Placement**





On
      February 16, 2007, the Company entered into a common stock purchase agreement
      (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
      liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
      Company's discretion, the Company may sell up to $10 million of the Company's
      common stock to Fusion Capital from time to time over a 25-month period. The
      Company has reserved for issuance up to 12,000,000 shares of the Company's
      common stock for sale to Fusion Capital under this agreement. Subject to earlier
      termination at the Company's discretion, Fusion Capital's purchase will occur
      after the Securities and Exchange Commission ("SEC") has declared effective
      the
      registration statement related to the transaction. The Company has issued to
      Fusion Capital 805,987 shares of the Company's common stock as a commitment
      fee
      for entering into the Purchase Agreement.





Concurrently
      with entering into the Purchase Agreement, the Company entered into a
      registration rights agreement with Fusion Capital (the “Registration Rights
      Agreement”). Under the Registration Rights Agreement, the Company agreed to file
      a registration statement with the SEC covering the shares that have been issued
      or may be issued to Fusion Capital under the Purchase Agreement. After the
      SEC
      has declared effective the registration statement, generally the Company has
      the
      right but not the obligation from time to time to sell shares of the Company's
      common stock to Fusion Capital in amounts between $100,000 and $1 million
      depending on certain conditions. The Company has the right to control the timing
      and amount of any sales of the Company's shares to Fusion Capital. The purchase
      price of the shares will be determined based upon the market price of the shares
      of common stock without any fixed discount. Fusion Capital shall not have the
      right or the obligation to purchase any shares of the Company's common stock
      on
      any business day that the price of the Company's common stock is below either
      $0.50 or $0.60, depending on the transaction size of the purchase. The agreement
      may be terminated by the Company at any time at its discretion without any
      cost
      to the Company.





During
      the quarter ended June 30, 2007, the Company executed five separate transactions
      under this agreement, selling a total of 970,994 shares of common stock at
      an
      average price of $0.515 per share for total proceeds of $500,000.





**2.
      Summary of Significant Accounting Policies**





**Principles
      of Consolidation**





The
      consolidated financial statements include the accounts of the Company and all
      affiliated subsidiaries. All significant inter-company balances and transactions
      have been eliminated in consolidation.





**Cash
      and Cash Equivalents**





The
      Company considers all highly liquid instruments with a maturity of three months
      or less at the time of issuance to be cash equivalents. As of June 30, 2007,
      cash deposits exceeded federally insured limits which are generally $100,000
      per
      financial institution.





**Restricted
      Cash**





On
      December 16, 2005, the Company completed a private placement of its common
      stock, whereby it received approximately $3.6 million which is restricted
      to operational costs associated with developing markets in Europe. Prior to
      2005, restricted cash consisted of cash held in the Company's bank account
      pursuant to the provisions set forth in documents to the acquisition of AAE
      on
      July 15, 2003. The restricted funds associated with the acquisition of AAE
      were released in equal amounts on October 15, 2003, and January 15,
      2004.





**Fair
      Value of Financial Instruments**





The
      carrying amounts of cash and cash equivalents, accounts receivable, due to/from
      related parties, other receivables, accounts payable, accrued expenses and
      deferred grants approximate fair value because of their short-term
      nature.





**Concentration
      of Credit Risk and Allowance for Doubtful Accounts**





The
      Company provides an allowance for doubtful accounts for estimated losses
      resulting from the inability of customers to make required payments. The Company
      does not require collateral and it does not charge finance fees on outstanding
      trade receivables. The allowance is determined by analyzing historical data
      and
      trends, as well as specific customers' financial conditions. Past-due or
      delinquency status is based upon the credit terms for that specific customer
      from the date of delivery. Charges for doubtful accounts are recorded in selling
      and marketing expenses. Trade accounts receivables are written off against
      the
      allowance for doubtful accounts when collection appears unlikely.




F-8




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Inventories**





Inventories,
      consisting of fuel additive held at third party locations, are stated at the
      lower of cost as determined using the first in, first out (FIFO) method, or
      market value.





**Furniture
      and Equipment and Depreciation**





Furniture
      and equipment are stated at cost, less accumulated depreciation. Depreciation
      is
      provided over the estimated useful lives of the assets using the straight-line
      method. The estimated useful lives of fixed assets are as follows:





Office
      furniture and equipment: 3 to 5 years


Fuel
      and
      test equipment: 5 years





Depreciation
      expense recorded in the accompanying Consolidated Statements of Operations
      was
      $20,780 and $41,696, respectively for the three and six months ended June 30,
      2006, and was $22,420, $44,015 and $327,779 respectively for the three and
      six
      months ended June 30, 2007 and for the period October 14, 2000
      (inception) through June 30, 2007.





**Accounting
      for Impairment of Intangible Assets**





The
      carrying values of intangible assets are reviewed on a regular basis for the
      existence of facts or circumstances that may suggest impairment. The Company
      recognizes impairment when the sum of the expected undiscounted future cash
      flows is less than the carrying amount of the asset. Impairment losses, if
      any,
      are measured as the excess of the carrying amount of the asset over its
      estimated fair value.





**Financial
      Instruments**





The
      carrying value of cash, accounts receivable, due to/from related parties, and
      accounts payable approximate fair value due to the relatively short maturity
      of
      these instruments.





**Revenue
      Recognition**





The
      Company sells its product directly to its customers and revenue is recognized
      and recorded upon the passage of title of the product to the customer and
      following confirmation that the customer is utilizing the final blended
      fuel.





The
      Company has developed the CityHomeTM program to serve as a key element of its
      sales/marketing and product demonstration strategy. This program involves the
      sale of our additive, the receipt of sponsorship fees and the potential sale
      of
      advertising space. As with other customers, revenue from the sales of product
      is
      recognized and recorded upon the passage of title of the product to the customer
      and following confirmation that the customer is utilizing the final blended
      fuel. Sponsorship fees will become additional revenue for us and will be
      recognized as such over the period of the contract when a sponsorship agreement
      is signed and the fees have been invoiced and payment has been assured. Costs
      that are intended to be supported by the sponsorship fees are recorded
      separately in the related expense line in our statement of operations. With
      regard to the advertising space, since the CityHomeTM program is still in a
      relatively undeveloped phase and since we have been unable to assess the
      fair market value of the advertising space received, we assign no value to
      the
      space at the time of receipt. We are recognizing the value associated with
      the
      advertising space when we enter into a contract arrangement with a third party.
      The Company will consider assigning a fair value to the advertising space
      received at the time of the initial sale when such fair value is more readily
      determinable, based upon a history of cash transactions.





The
      Company has supported certain fleet equipment conversion costs in these
      CityHomeTM initiatives and has also been required to bear the incremental costs
      of the blended fuel, where it is experienced. Whenever the expected costs of
      the
      program are determined to be in excess of the contracted sponsorship fees and
      related fuel additive revenue, the Company records the loss for the contract
      as
      an expense and a deferred liability to be amortized over the life of the
      contract. As of June 30, 2007, costs remaining to be amortized for CityHomeTM
programs were recorded on the balance sheet as Deferred Marketing Program in
      the
      amount of $98,000. The Company recorded $69,480 and $88,753 in costs for the
      CityHomeTM initiatives during the three and six months ended June 30, 2006 and
      $69,334, $86,393 and $1,208,129 of costs for CityHomeTM initiatives for the three
      and six months ended June 30, 2007 and for the period October 14, 2000
      (inception) through June 30, 2007, respectively.





**Shipping
      and Handling Costs**





The
      Company classifies costs associated with shipping and handling activities within
      cost of goods sold in the consolidated statements of operations. Shipping and
      handling costs were $4,766 and $7,703 for the three and six months ended June
      30, 2006 and were $3,853, $14,058 and $65,750 respectively for the three and
      six
      months ended June 30, 2007 and for the period October 14, 2000
      (inception) through June 30, 2007.




F-9





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Advertising
      Expenses**





Advertising
      costs are expensed as incurred. Advertising expense was $0 for the three and
      six
      months ended June 30, 2007 and 2006, and was $450,000 for the
      period October 14, 2000 (inception) to June 30, 2007.





**Research
      and Development Costs**





Research
      and development costs are expensed as incurred.





**Product
      Test and Demonstration Appropriations**





The
      Company receives appropriations from U.S. governmental agencies to fund certain
      of its product testing and demonstration programs. The Company evaluates the
      conditions of the appropriation and either increases revenue, decreases expenses
      or reduces the cost of furniture and equipment depending upon the attributes
      of
      the underlying grant. Appropriations are not recognized until there is
      reasonable assurance that the Company will comply with the conditions of the
      grant and that the monies under the grant will be received.





**Net
      Loss Per Common Share (Basic and Diluted)**





Basic
      net
      loss per common share is computed by dividing the net loss available to common
      stockholders by the weighted average number of common shares outstanding during
      the period. Diluted net loss per share gives effect to all dilutive potential
      common shares outstanding during the period using the if-converted method.
      Diluted net loss per share excludes all potential dilutive common shares if
      their effect is anti-dilutive. The weighted average number of shares used to
      compute basic and diluted loss per share is the same since the effect of the
      dilutive securities is anti-dilutive.





**Accounting
      for Stock-Based Compensation**





Effective
      January 1, 2006, the Company adopted the fair value recognition provisions
      of Statement of Financial Accounting Standard ("SFAS") No. 123(R), using the
      modified prospective transition method. SFAS No. 123(R) requires all
      share-based payments to employees, including grants of employee stock options,
      to be recognized in the financial statements based on their fair values
      beginning with the first annual reporting period that begins after
      December 15, 2005, with early adoption encouraged.





The
      Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
      which the Board of Directors has authorized 9,750,000 shares of common stock
      to
      be reserved for future issuance under the Incentive Plan. Stock options
      generally vest over three years and will expire 10 years from the effective
      date. However, the Company has the latitude under the Incentive Plan to issue
      options at various stages of vesting.





Once
      these options are granted by the Board under the provisions of the plan, the
      Company will record a compensation charge for the difference between the fair
      value of the common stock and the exercise price of the options on the date
      of
      issuance if the fair value of the common stock exceeds the exercise price of
      the
      option on that date. The fair value of each option granted is estimated on
      the
      date of grant using the Black-Scholes option-pricing model. The assumptions
      used
      with this model for 2006 were an expected life of three years, a zero dividend
      yield, volatility ranging from 72% to 209% (depending on date of grant), and
      risk free interest rates ranging from 4.64% to 5.09% (depending on date of
      grant). The assumptions used with this model for 2005 were an expected life
      of
      3 years, a zero dividend yield, volatility ranging from 59% to 120%
      (depending on date of grant), and risk free interest rates ranging from 3.39%
      to
      3.96% (depending on date of grant). The estimated fair value of the options
      is
      amortized over the option's vesting period. During the six months ended June
      30,
      2007, no additional options were granted.





**Income
      Taxes**





Income
      taxes are accounted for using the liability method in accordance with SFAS
      No. 109, “Accounting for Income Taxes.” Under SFAS 109, deferred tax assets
      or liabilities are computed based upon the difference between the financial
      statement and income tax bases of assets and liabilities using the enacted
      marginal tax rate applicable when the related asset or liability is expected
      to
      be realized or settled. Deferred income tax expense or benefits are based on
      the
      changes in the asset or liability from period to period. If available evidence
      suggests that it is more likely than not that some portion or all of a deferred
      tax asset will not be realized, a valuation allowance is recorded to reduce
      the
      deferred tax assets to the amount that is more likely than not to be realized.
      Future changes in such valuation allowance would be included in the provision
      for deferred income taxes in the period of change.




F-10




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Use
        of Estimates**





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States requires management to make estimates
      and assumptions that affect the reported amounts of assets and liabilities
      and
      disclosure of contingent assets and liabilities at the date of the financial
      statements and the reported amounts of revenues and expenses during the
      reporting periods. Actual results could differ from those
      estimates.





**Foreign
      Subsidiaries**





The
      Company has foreign subsidiaries whose local currency has been determined to
      be
      the functional currency. For these foreign subsidiaries, the assets and
      liabilities have been translated using the current exchange rates, and the
      income and expenses have been translated using the weighted average of
      historical exchange rates during the reporting period. The adjustments resulting
      from translation have been recorded separately in stockholders' equity as “other
      comprehensive income (loss)” and are not included in determining the
      consolidated net loss. As of June 30, 2007, accumulated other comprehensive
      income included $5,431 of cumulative income from foreign currency
      translation.





The
      Company began operations in Brazil in March of 2004 by establishing a 75% owned
      subsidiary. The Brazilian subsidiary recognized $0 and $0 in revenue for the
      three and six months ended June 30, 2006, and was $0, $0, and $7,682 for the
      three and six months ended June 30, 2007, and the period October 14, 2000
      (inception) through June 30, 2007, respectively, and had total assets less
      current liabilities (exclusive of intercompany amounts eliminated in
      consolidation) of $71,760 at June 30, 2007. Transactions in Brazil are
      denominated in, and the functional currency is, the Brazilian Real. Accordingly,
      no currency exchange rate gains or losses are recorded in the accompanying
      consolidated statement of operations for Brazilian operations. At June 30,
      2007,
      the Brazilian operations had aggregate losses of $1,817,354. The minority
      stockholder's portion of aggregate losses is not recorded in the consolidated
      balance sheet since reimbursement of this amount from the minority stockholders
      is not assured.





The
      Company began operations in Spain in April of 2006 by establishing a 100%
      subsidiary. The Spanish subsidiary did not recognize any revenue for the three
      and six months ended June 30, 2007, nor the period April 2006 through June
      30,
      2007. At June 30, 2007, the Spanish subsidiary had total assets less current
      liabilities (exclusive of intercompany amounts eliminated in consolidation)
      of
      $3,769. Transactions in Spain are denominated in and the functional currency
      is
      the Euro. At June 30, 2007, the Spanish operations had aggregate losses of
      $957,248.




F-11





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





On
      December 31, 2004, the Company ceased operations at two of its wholly-owned
      subsidiaries in the United Kingdom. In connection with the cessation, the
      Company recorded an exchange gain in the 2004 consolidated statement of
      operations of $94,396 to recognize cumulative translation gains previously
      recorded in other comprehensive income (loss). The subsidiaries were primarily
      holding companies and had no assets or liabilities as of December 31, 2004.
      For the year ended December 31, 2005 and December 31, 2006 and for the three
      and
      six months ended June 30, 2007, these subsidiaries incurred no activity and
      therefore had no profit or loss.





**Segment
      Reporting**





The
      Company is a development stage company and has not made sales of its products
      in
      commercial volumes. Management believes that the Company currently operates
      and
      manages the business as one business segment.





**Impairment
      of Intellectual Property Rights**





Prior
      to
      the fourth quarter of 2002, the Company was pursuing the marketability of a
      technology it had acquired for $424,659. In December, 2002, the Company
      determined that the related product was no longer commercially viable and would
      no longer be pursued. As a result of this decision, it was determined that
      the
      asset would not be recoverable as there was no alternative market for the
      technology. Accordingly, the net book value of $345,115 was charged to general
      and administrative expenses during 2002.





**Interim
      Financial Statements**





The
      unaudited interim consolidated financial statements of the Company have been
      prepared in accordance with accounting principles generally accepted in the
      United States for interim financial information. In the opinion of management,
      all adjustments (consisting of normal recurring adjustments) considered
      necessary to present fairly the financial position of the Company as of June
      30,
      2007 and the results of operations and cash flows presented herein for the
      three
      and six month periods ended June 30, 2007 and 2006 and from inception
      (October 14, 2000) through June 30, 2007 have been included in the
      financial statements. Interim results are not necessarily indicative of results
      of operations that may be expected for the year ending December 31, 2007.
      It is recommended that this financial information be read with the complete
      financial statements included in the Company's Form 10-KSB dated
      December 31, 2006 filed with the SEC on March 27, 2007.





**3.
      Government Appropriations**





**Appropriation
      from the U.S. Department of Energy (1)**





In
      2002,
      the Company received an appropriation of $1,107,734 from the U.S. Department
      of
      Energy (“DOE”) to test the Company's fuel additive as well as its blended fuel,
      O2DieselTM. The appropriation was increased to $2,039,651 as of
      September 15, 2004. This appropriation is managed for the DOE by the
      National Renewable Energy Laboratory (“NREL”) under a contract which, as
      amended, continued until June 30, 2007. Under the terms of the contract,
      the Company is reimbursed by NREL for 80% of the costs incurred to complete
      the
      Statement of Work as set forth in the contract. The Company charges all expenses
      as incurred to operations and accrues all amounts receivable under the contract
      as a reduction to contract expenses when the Company is reasonably certain
      all
      conditions of the reimbursement are satisfied. As of June 30, 2007, the Company
      had incurred the full cumulative costs of $2,039,651 towards completion of
      the
      contract and is in the process of closing the contract. From the inception
      of
      the contract in December 2002 through June 30, 2007, the Company billed
      NREL $1,631,720 of which $37,120 is included in other receivables as of
      June 30, 2007.





**Appropriation
      from the U.S. Department of Energy (2)**





In
      2003,
      the Company received an appropriation of $1,123,834 to test the Company's fuel
      additive under the California Air Resources Board (CARB) Diesel Emissions
      Control Strategy (DECS) verification rules. The Company is eligible to
      receive reimbursements of 80% of costs incurred under a contract up to the
      appropriation amount. This appropriation is managed for the DOE by NREL. As
      of
      June 30, 2007, the Company had incurred cumulative costs of $768,435 towards
      completion of the contract, leaving a balance of $355,399 in costs to complete
      the contract. From the inception of the contract through June 30, 2007, the
      Company billed NREL $614,748 of which $154,608 is included in other receivables
      as of June 30, 2007.





**Appropriation
      from the U.S. Department of Energy (3)**





During
      2004 and 2005, the Company has received $1,000,000 in available appropriations
      for the purpose of continued testing and verification of our fuel additive.
      The
      Company submitted a proposal to NREL and expects to have these funds under
      contract by the end of the third quarter 2007. These projects would be eligible
      for 80% reimbursement.




F-12




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Appropriation
      from the U.S. Department of Defense (1)**





In
      2003,
      the Company received an appropriation of $1,000,000 from the U.S. Department
      of
      Defense to test O2DieselTM fuel in non-strategic military vehicles operated by
      the U.S. Air Force at Nellis Air Force Base in Las Vegas, Nevada. Under the
      terms of this Appropriation, a third party is to be paid $200,000 to administer
      this program on behalf of the Department of Defense. The remaining $800,000
      is
      to be used to fund purchases of O2DieselTM fuel, certain capital equipment and to
      reimburse the Company for its labor, overhead and out-of-pocket costs required
      to complete this project. Under this program, the Company is required to meet
      certain milestones as a condition to receiving reimbursements for its costs.
      Thus, upon achieving a milestone, the Company accrues the amount due and submits
      an invoice for reimbursement. All amounts are expensed as incurred, and all
      amounts receivable for work completed are treated as a reduction to expense
      over
      the period earned. The period of performance for this program ran from
      October 7, 2003 to December 31, 2004. Through December 31, 2004,
      the Company had achieved five milestones and, since inception, has billed
      $360,000 related to this appropriation, of which $160,000 was billed in January,
      2005. By its terms, this contract expired on December 31, 2004 and was not
      extended. No activity under this appropriation has taken place subsequent to
      March 31, 2005. The work required to achieve the milestones not completed
      as of December 31, 2004, has been included as part of the Statement of Work
      for Appropriation (2) from the U.S. Department of Defense as is permitted
      under that contract. However, the funds from Appropriation (1) cannot be
      applied to Appropriation (2). Through December 31, 2005, the Company has
      received cash in excess of costs incurred of $296,097 and has recorded Deferred
      Grants at December 31, 2005 in the Consolidated Balance Sheet. All amounts
      billed had been received as of December 31, 2005. No additional reimbursements
      are expected from this appropriation. During the fourth quarter of 2006 the
      Company was notified from the subcontractor that the contract was officially
      closed and O2Diesel has no further requirements. Based on this information,
      the
      Company applied the previously recorded liability of $296,097 for this contract
      as an offset to 2006 grant expenses for the year ended December 31,
      2006.





**Appropriation
      from the U.S. Department of Defense (2)**





On
      January 11, 2005, the Company entered into a contract with a value of
      $1,085,000 with the U.S. Department of Defense. Under this contract, the
      Company's O2DieselTM fuel is to be tested in a maximum of forty
      (40) non-tactical vehicles at US Air Force bases in Nevada for an
      18 month period. Furthermore, the Company is to complete certain engine
      testing and other work required for the acceptance of O2DieselTM as a viable
      alternative fuel for use by the Air Force. Work on this contract commenced
      on
      November 1, 2004 and was to continue through November 30, 2006.
      Notwithstanding that the agreement for this contract was signed in
      January 2005, the Company was asked to begin work in 2004 and, by a letter
      from Innovative Technologies Corporation (ITC), was authorized to incur costs
      in
      an amount not to exceed $75,000. This is a time and materials contract that
      is
      administered for the U.S. Department
      of Defense by a third party contractor. The Company charges all costs as
      incurred to expense and accrues all amounts receivable under the contract as
      a
      reduction to contract expenses. The contract amount was amended in May 2006
      to
      $1,012,564. The amount of the reduction will be added to a future contract
      through the Air Force. Billings under this contract are made monthly. As of
      December 31, 2006, costs totaling $1,011,215 had been incurred, billed, and
      received. As of June 30, 2007, there is a balance of $1,349 in the contract,
      but
      no further activity is expected. The contract will be officially closed out
      in
      2007.





**Appropriation
      from the U.S. Department of Defense (3)**





The
      Company received an appropriation during 2005 of approximately $910,000 from
      the
      U.S. Department of Defense. Concurrent Technologies Corporation
      (CTC) manages this appropriation on behalf of the Department of Defense.
      This contract contains a payment schedule based on meeting performance
      milestones. Six milestones were achieved by June 30, 2007. The primary objective
      of this contract is to create potential fuels using the Company additive that
      contain no more than 80% petroleum. If this project is successful, an
      application will be made to EPA for “alternative fuel” status, creating an
      incentive for federal customers to use the fuel. Part of this research entails
      conducting demonstrations in various climates at three Air Force bases,
      including Nellis Air Force Base (expanded fleet) in Nevada. As of June 30,
      2007,
      the Company has recorded expenses of $711,829 against this contract, leaving
      a
      balance of $198,171. The Company invoiced $630,000 for the six milestones on
      this project through June 30, 2007, of which $75,000 was recorded in other
      receivables as of June 30, 2007. The Company also recorded $81,829 as an
      unbilled receivable under this appropriation as of June 30, 2007.





**Appropriation
      from the U.S. Department of Defense (4)**





In
      2005,
      the Company received an appropriation of approximately $1,100,000 for continued
      testing and verification of O2DieselTM. As of June 30, 2007, the Company has
      executed a contract for $575,000. As of June 30, 2007, the Company has recorded
      expenses of $54,994 against this contract, leaving a balance of $520,006. The
      Company invoiced $398,593 for four milestones on this project through June
      30,
      2007, of which $149,923 was recorded in other receivables as of June
      30, 2007. In addition, the Company recorded $343,599 as a deferred grant on
      the
      balance sheet at June 30, 2007.




F-13




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Appropriation
      from the U.S. Department of Defense (5)**





In
      2006,
      the Company received an appropriation of approximately $1,000,000 for continued
      testing and verification of O2DieselTM. The Company expects to enter into a
      contract for this work during the third quarter of 2007. The Company can receive
      reimbursement from this appropriation of up to the entire
      $1,000,000.





**4.
      Other Receivables**




June
                30, 2007Due
                from ProEco
            
            $
            735,000NREL
                Appropriation
            
            
            191,728CTC
                Appropriation
            
            
            224,923Reimbursement
                of expenses and services performed
            
            
            33,663$
            1,185,314


**5.
      Accrued Expenses**




June
                30, 2007Legal
                and professional
            
            $
            145,262Investor
                Relations
            
            
            10,000Other
            
            
            133,662$
            288,924




**6.
      Deferred Financing and Business Acquisition Costs**





During
      2003, management began the public listing process on the Alternative Investment
      Market (AIM) in London, England. All legal, accounting, and other related costs
      incurred in connection with the AIM listing were capitalized as deferred
      financing costs. In December 2003, management determined that the Company
      would terminate its plan to seek an AIM listing. Accordingly, deferred financing
      costs of $517,000, were charged to expense for the year ended December 31,
      2003.





The
      Company records the cost of equity financings as a reduction of the associated
      proceeds.





**7.
      Income Taxes**





No
      provision for Federal and state income taxes has been recorded during the
      periods presented due to the Company's significant operating losses. The income
      tax benefit reflected in the accompanying consolidated statement of operations
      is the current benefit recognized in Ireland for the periods
      presented.





Deferred
      income taxes reflect the net tax effects of temporary differences between the
      carrying amounts of assets and liabilities for financial reporting purposes
      and
      the amounts used for income tax reporting purposes. Significant components
      of
      the Company's deferred tax asset as of June 30, 2007:




Income
                taxesNet
                operating loss carryforwards
            
            $
            10,503,000Deferred
                revenue
            
            
            533,000Accrued
                expenses
            
            
            109,000Total
                deferred tax assets
            
            
            11,145,000Valuation
                allowance
            
            
            (11,145,000
            )Net
                deferred tax assets
            
            $
            --





F-14




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





Management
      has determined that a valuation allowance equal to 100% of the existing deferred
      tax assets is appropriate given the uncertainty regarding the ultimate
      realization of these assets. At June 30, 2007, the Company had Federal and
      state
      net operating loss carryforwards of approximately $25.6 million for income
      tax purposes. If not used, these carryforwards expire through 2021 for Federal
      and state tax purposes. As of June 30, 2007, the Company had an Irish net
      operating loss carryforward of approximately $613,000 which can be carried
      forward indefinitely, cumulative Spanish losses of approximately $925,000 and
      a
      Brazilian net operating loss of approximately $1,565,000 that may be carried
      forward indefinitely, but which is subject to annual usage
      limitations.


In
        July
        2006, The Financial Accounting Standards Board ("FASB") issued FASB
        Interpretation No. 48, “Accounting for Uncertainty in Income Taxes- an
        interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the
        accounting and disclosure for uncertainty in tax positions, as defined and
        prescribes the measurement process and a minimum recognition threshold, for
        a
        tax position taken or expected to be taken in a tax return, that is required
        to
        be met before being recognized in the financial statements. Under FIN 48,
        the
        Company must recognize the tax benefit from an uncertain tax position only
        if it
        is more likely than not that the tax position will be sustained on examination
        by the taxing authorities, based on the technical merits of the position.
        The
        tax benefits recognized in the financial statements from such a position
        are
        measured based on the largest benefit that has a greater than 50% likelihood
        of
        being realized upon ultimate resolution.
 
 The
        Company is subject to the provisions of FIN 48 as of January 1, 2007, and
        has
        analyzed filing positions in all of the U.S. federal and state jurisdictions
        where it is required to file income tax returns, its federal and state tax
        returns in Ireland, Spain and Brazil and all open tax years in these
        jurisdictions. The Company has identified its U.S. federal tax return and
        its
        state tax returns in Delaware and California as “major” tax jurisdictions as
        defined. Based on the Company’s evaluation, we have concluded that there are no
        significant uncertain tax positions requiring recognition in our financial
        statements. Our evaluation was performed for the tax years which remain subject
        to examination by the major U.S. tax jurisdictions (tax years ended December
        31,
        2003 to December 31, 2006) and for the tax years which remain open for
        examination in Ireland (December 31, 2006), Spain (December 31, 2006) and
        Brazil
        (December 31, 2006). Based on this evaluation, no reserves for uncertain
        income
        tax positions have been recorded pursuant to FIN 48 during the period ended
        June
        30, 2007 and the Company does not anticipate that it is reasonably possible
        that
        any material increase or decrease in its unrecognized tax benefits will occur
        within twelve months. In addition, the Company did not record a cumulative
        effect adjustment related to the adoption of FIN 48.
 
 Upon
        adoption on January 1, 2007 and as of June 30, 2007, the Company had no
        unrecognized tax benefits or accruals for the potential payment of interest
        and
        penalties. The Company’s policy for recording interest and penalties associated
        with tax audits is to record such items as a component of income or loss
        before
        provision (benefit) for income taxes. Penalties are recorded in other expenses
        and interest paid or received is recorded in interest expense or interest
        income
        related to the settlement of tax audits for certain prior periods. For the
        period ended June 30, 2007, there were no interest or penalties recorded
        relating to the settlement of tax audits.




Federal
      tax rules under Section 382 of the Internal Revenue Code of 1986 impose
      limitations on the use of net operating losses following certain changes in
      ownership. If such a change occurs, the limitation would reduce the amount
      of
      the benefits that would be available to offset future taxable income each year,
      starting with the year of ownership change. In general, an ownership change,
      as
      defined by Section 382, results from transactions increasing the ownership
      of
      certain shareholders or public groups in the stock of a corporation by more
      than
      50 percentage points over a there-year period. Since the Company’s formation,
      the Company has raised capital through the issuance of capital stock on several
      occasions which, combined with the purchasing shareholders’ subsequent
      disposition of those shares, may have resulted in a change of control, as
      defined by Section 382, or could result in a change of control in the future
      upon subsequent disposition. The Company has not currently completed a study
      to
      assess whether a change of control has occurred or whether there have been
      multiple changes of control since the Company’s formation due to the significant
      complexity and cost associated with such study and that there could be
      additional changes in control in the future. If we have experienced a change
      of
      control at any time since the Company’s formation,
      utilization of our NOL carryforwards would be subject to an annual limitation
      under Section 382. Any limitation may result in the expiration of a portion
      of
      the NOL carryforwards before utilization. Further, until a study is completed
      and any limitation is known, no amounts are being presented as an uncertain
      tax
      position under FIN 48.





**8.
      Stockholders' Equity**





**Recapitalization**





On
      July 15, 2003, O2Diesel Corporation and AAE Technologies International Plc
      (“AAE”) entered into a merger transaction whereby O2Diesel acquired all of
      the issued and outstanding share capital of AAE in exchange for the issuance
      of
      17,847,039 shares of common stock of O2Diesel. Although O2Diesel was the legal
      acquirer, AAE was deemed to be the accounting acquirer. The transaction was
      accounted for as an AAE capital transaction, accompanied by a
      recapitalization.





As
      a
      result of the transaction, the historical financial statements of AAE are deemed
      to be those of the Company for financial reporting purposes. The equity accounts
      of AAE have been adjusted for the recapitalization to reflect the equity
      structure of O2Diesel, the legal acquirer. Specifically, the historical
      stockholders' equity of AAE prior to the transaction has been affected for
      the
      equivalent number of shares of O2Diesel common stock received in the
      transaction, with an offset to paid-in capital; the accumulated deficit of
      AAE
      was carried forward after the transaction; and the loss per share for all
      periods prior to the transaction was restated to reflect the number of
      equivalent common shares received by AAE in the transaction.





**Issuances
      of Common Stock**





In
      connection with the merger between O2Diesel and AAE in July 2003, the
      Company completed a private placement of 3,333,333 shares of common stock at
      $1.50 per share. The private placement was partially effectuated through the
      issuance of a $4 million convertible note that was convertible into the
      Company's common stock at $1.50 per share. In October 2003, the Company
      repaid $1,677,500 of the note and the $2,322,500 balance was converted into
      1,548,333 shares of common stock. The remaining 1,785,000 shares of common
      stock
      issuable under the private placement were issued to other parties in exchange
      for cash proceeds of $2,677,500. The expenses associated with the merger and
      subsequent issuances of shares were $795,650 and have been reflected as a
      reduction of paid-in capital.





Subsequent
      to its first private placement in 2003, the Company undertook to raise an
      additional $3.5 million through a follow-on private placement of our common
      stock (the “Follow-On Private Placement”). In the Follow-On Private Placement,
      we raised $1,535,770, before expenses, and issued 1,025,784 shares of our common
      stock at a price of $1.50 per share. The Follow-On Private Placement was closed
      on March 31, 2004. There was no underwriter involved in the Follow-On Private
      Placement. Sales of common stock under the Follow-On Private Placement that
      were
      completed in non-U.S. transactions were exempt from registration pursuant to
      Regulation S promulgated under the Securities Act of 1933. The sales of common
      stock under the Follow-On Private Placement to accredited U.S. investors were
      exempt pursuant to Regulation D promulgated under the Securities
      Act.





**$2.0
      and $3.0 Million Private Placements**





In
      a
      series of two private placements of the Company’s common stock in 2005, the
      Company raised $4,833,192 after payment of an 8% commission and other expenses,
      and issued 7,535,981 shares of common stock at a price of $0.70 per share.
      Subscribers to these




F-15





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





private
      placements received for each two shares of common stock purchased one warrant
      to
      purchase one additional share of common stock. The warrant expires twenty-four
      months following the closing of the private placement. Each warrant is
      exercisable at a price of $0.70 per share during the first twelve months
      following the close of the private placement, or at an exercise price of $1.05
      per share in the second twelve months following the close of the private
      placement. The total number of warrants issued was 3,757,990. The common stock
      and the warrants were issued to the accredited investors in a transaction that
      will be exempt from registration pursuant to Section 4(2) of the Securities
      Act,
      and/or Regulation D promulgated under the Securities Act.





**$2.3
      Million Private Placement**





On
      October 24, 2005, the Company issued 3,228,070 shares of common stock at a
      purchase price of $0.7125 per share in a private placement for total proceeds
      of
      $2,300,000.





As
      part
      of this sale, the Company also issued warrants to purchase 1,614,035 shares
      of
      common stock at an exercise price of $1.425 per share during the period of
      six
      months to forty-two months subsequent to issuance or at a cashless exercise
      if a
      registration statement is not effective within one year of issuance. The
      warrants expire forty-two months after the date of issuance.





As
      part
      of the transaction, the Company agreed to sell up to an additional $700,000
      of
      its common stock to the Purchaser at a purchase price of $0.7125 per share
      for
      982,456 shares. The Company also issued warrants to purchase 491,228 shares
      of
      common stock at an exercise price of $1.425 per share during the period of
      six
      months to forty-two months subsequent to issuance or at a cashless exercise
      if a
      registration statement is not effective within one year of issuance. The
      warrants expire forty-two months after the date of issuance. The purchaser
      had
      180 days following the date of the Purchase Agreement to acquire additional
      shares. This offer expired unexercised on March 20, 2006.





The
      Company agreed to issue warrants to purchase 1,614,035 shares of common stock
      at
      an exercise price of $0.7125 per share to its advisor in connection with this
      transaction. The warrants expire forty-two months after the date of issuance.
      The common stock and the warrants were issued to the accredited investor in
      a
      transaction that will be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act, and/or Regulation D promulgated under the Securities
      Act.





**$3.6
      Million Private Placement**





On
      December 16, 2005, the Company issued 6,419,840 shares of the Company's common
      stock in a private placement, for total proceeds of 3,000,000€, or approximately
      $3.6 million at the then current exchange rates.





As
      part
      of the transaction, the Company issued warrants to purchase 2,853,262 shares
      of
      common stock at an exercise price of $0.85 per share during the period six
      to
      forty two months subsequent to the date of issuance or at an exercise price
      of
      $1.13 per share during the period forty three to sixty six months after the
      date
      of issuance. The warrants expire sixty six months after the date of
      issuance.





**$4.0
      and $2.5 Million Private Placements** ****





On
      April
      6, 2006, the Company entered into a Common Stock and Warrant Purchase Agreement
      (“$4.0 million Purchase Agreement”) with a UK investor (the “Investor”) for
      5,333,333 shares of common stock at a purchase price of $0.75 per share in
      a
      private placement for total proceeds of $4,000,000 (the “$4.0 million Private
      Placement”). As part of this sale, the Company also issued warrants to purchase
      2,666,667 shares of common stock at an exercise price of $0.825 per share during
      the period of six months to forty-two months subsequent to issuance. The
      warrants expire forty-two months after the date of issuance.





Also
      on
      April 6, 2006, the Company entered into a Common Stock and Warrant Purchase
      Agreement (“$2.5 million Purchase Agreement”) with a different European
      investor (the “2 nd Investor”) for 3,333,333 shares of common stock at a purchase price of $0.75 per
      share in a private placement for total proceeds of $2,500,000 (the “$2.5 million
      Private Placement”) before payment of a 9% commission and other expenses.
      As part of this sale, the Company also issued warrants to purchase 1,666,667
      shares of common stock at an exercise price of $0.825 per share during the
      period of six months to forty-two months subsequent to issuance. The warrants
      expire forty-two months after the date of issuance.





Subsequent
      to entering into these agreements, the Company entered into an identical
      amendment to each agreement which (i) modified the amount of liquidated damages
      to a maximum of 8% of the purchase price and (ii) added that stockholder
      approval will be obtained prior to the Company issuing the shares of common
      stock issuable upon exercise of the warrants. There were no other changes to
      either agreement. Both transactions closed and the warrants were issued on
      April
      27, 2006.





AMEX
      requires that stockholder approval be obtained by the Company for the sale
      of
      common stock in a transaction if the price of the shares to be sold is less
      than
      the greater of book or market value, and the number of shares is equal
      twenty-percent (20%) or more of the presently outstanding common stock. In
      order
      to comply with this requirement, the Company was required to obtain shareholder
      approval for the $4.0 and the $2.5 million Private Placements. Stockholder
      approval was obtained at the Company's annual stockholder meeting on July 6,
      2006.


F-16




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**$1.0
      Million Private Placement**





On
      November 9, 2006, the Company issued 1,371,742 shares of the Company's common
      stock at a purchase price of $0.729 per share in a private placement for total
      proceeds of $1,000,000.





As
      part
      of the sale, the Company issued warrants to purchase 685,871 shares of common
      stock at an exercise price of $0.972 per share during the period of six months
      to sixty-six months subsequent to issuance. The warrants expire
      sixty-six months after the date of issuance.





The
      common stock and the warrants were issued to the accredited investor in a
      transaction that is exempt from registration pursuant to Section 4(2) of
      the Securities Act, and/or Regulation D promulgated under the Securities
      Act.





The
      transaction closed and the funds were received on November 22,
      2006.





**$10.0
      Million Private Placement**





On
      February 16, 2007, the Company entered into a common stock purchase agreement
      (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
      liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
      Company's discretion, the Company may sell up to $10 million of the Company's
      common stock to Fusion Capital from time to time over a 25-month period. The
      Company has reserved for issuance up to 12,000,000 shares of the Company's
      common stock for sale to Fusion Capital under this agreement. Subject to earlier
      termination at the Company's discretion, Fusion Capital's purchases will occur
      after the SEC has declared effective the registration statement related to
      the
      transaction. The Company has issued to Fusion Capital 805,987 shares of the
      Company's common stock as a commitment fee for entering into the Purchase
      Agreement.





Concurrently
      with entering into the Purchase Agreement, the Company entered into a
      registration rights agreement with Fusion Capital (the “Registration Rights
      Agreement”). Under the Registration Rights Agreement, the Company agreed to file
      a registration statement with the SEC covering the shares that have been issued
      or may be issued to Fusion Capital under the Purchase Agreement. After the
      SEC
      has declared effective the registration statement, generally the Company has
      the
      right but not the obligation from time to time to sell shares of the Company's
      common stock to Fusion Capital in amounts between $100,000 and $1 million
      depending on certain conditions. The Company has the right to control the timing
      and amount of any sales of the Company's shares to Fusion Capital. The purchase
      price of the shares will be determined based upon the market price of the shares
      of common stock without any fixed discount. Fusion Capital shall not have the
      right or the obligation to purchase any shares of the Company's common stock
      on
      any business day that the price of the Company's common stock is below either
      $0.50 or $0.60, depending on the transaction size of the purchase. The agreement
      may be terminated by the Company at any time at its discretion without any
      cost
      to the Company.





**Issuances
      of Preferred Stock**





**Series A
      0% Convertible Preferred Stock Private Placement**




Pursuant
      to a Convertible Preferred Stock Purchase Agreement between the Company and
      the
      purchaser named therein (the “Series A Purchaser”) dated as of
      March 3, 2004, the Company issued to the Series A Purchaser, 800,000
      shares of Series A 0% Convertible Preferred Stock, par value $.0001
      (“Series A Preferred Stock”). The offering resulted in gross proceeds of
      approximately $3,200,000 to
      the
      Company, prior to the deduction of fees and commissions. The sale of the
      Series A Preferred Stock was exempt from registration pursuant to
      Regulation S promulgated under the Securities Act.





The
      Series A Preferred Stock was initially convertible into the Company's
      common stock at a variable conversion ratio which was the lesser of (a) $4.00
      as
      adjusted as provided in the Series A Certificate of Designation (the
“Series A Fixed Conversion Price”) or (b) eighty percent (80%) of the
      lowest closing bid price for the Common Stock in the ten business days preceding
      the date of conversion, but, in no case, less than 50% of the Series A
      Fixed Conversion Price. In September 2004, we renegotiated the conversion
      formula with the holder of these shares. Thus, the minimum price at which the
      shares may be converted is equal to twenty-five percent (25.0%) of the Fixed
      Conversion Price, or $1.00 per share. Pursuant to the amended agreement, the
      Series A Purchaser may not convert Series A Preferred Stock into our
      common stock for a period of two (2) years following the closing date of
      this transaction. Under the revised agreement, in no event will the
      Series A Purchaser receive more than 8,000,000 or less than 2,000,000
      shares of the Company's common stock upon conversion of the Series A
      Preferred Stock.





The
      Series A Purchaser was granted an option to purchase additional shares of
      the Company's common stock equal to the difference between the number of shares
      of common stock actually received upon conversion and the number of shares
      that
      would have been received at a conversion price of $1.82. The exercise price
      shall be the Series A Fixed Conversion Price.





F-17




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Series B
      0% Convertible Preferred Stock Private Placement**




Pursuant
      to a Convertible Preferred Stock Purchase Agreement between the Company and
      the
      purchaser named therein (the “Series B Purchaser”) dated as of
      March 29, 2004, the Company issued to the Series B Purchaser, 750,000
      shares of Series B 0% Convertible Preferred Stock, par value $.0001
      (“Series B Preferred Stock”). The offering resulted in gross proceeds
      of approximately $3,000,000 to the Company, prior to the deduction of fees
      and
      commissions. The sale of the Series B Preferred Stock was exempt from
      registration pursuant to Regulation S promulgated under the Securities
      Act.




The
      Series B Preferred Stock was initially convertible into the Company's
      common stock at a variable conversion ratio which was the lesser of (a) $3.65
      as
      adjusted as provided in the Series B Certificate of Designation (the
“Series B Fixed Conversion Price”) or (b) eighty percent (80%) of the
      lowest closing bid price for the Common Stock in the ten business days preceding
      the date of conversion,
      but, in no case, less than 50% of the Series B Fixed Conversion Price. In
      September 2004, we renegotiated the conversion formula with the holder of these
      shares. Thus, the minimum price at which the shares may be converted is equal
      to
      twenty-seven and four tenths per cent (27.4%) of the Series B Fixed
      Conversion Price, or $1.00 per share. Pursuant to the amended agreement, the
      Series B Purchaser may not convert Series B Preferred Stock into our
      common stock for a period of two (2) years following the closing date of
      this transaction. Under the revised agreement, in no event will the
      Series B Purchaser receive more than 7,500,000 or less than 2,054,795
      shares of the Company's common stock upon conversion of the Series B
      Preferred Stock.




The
      Series B Purchaser was granted an option to purchase additional shares of
      the Company's common stock equal to the difference between the number of shares
      of common stock actually received upon conversion and the number of shares
      that
      would have been received at a conversion price of $1.82. The exercise price
      shall be the Series B Fixed Conversion Price.





In
      April
      2006, the holders of both the Series A and Series B Convertible Preferred Stock
      exercised all of their conversion rights and converted 1,550,000 shares of
      Convertible Preferred Stock into 15,500,000 shares of common stock.





**Warrants**





A
      wholly-owned subsidiary of the Company entered into a supply and distribution
      agreement (the “Distribution Agreement”) with a distributor dated July 10,
      2001 that granted the distributor the right to purchase up to 10% of the
      outstanding common stock of the Company for $1.00 per share should certain
      sales
      targets be achieved. The warrant was to expire on July 10, 2006. None of
      the sales targets have been achieved under the Distribution Agreement and as
      of
      December 10, 2004 this Distribution Agreement was terminated and replaced
      by a new supply and distribution agreement (the “New Agreement”). Under this New
      Agreement, the distributor received a warrant to purchase 600,000 shares of
      O2Diesel's common stock at a price of $2.00 per share, which expired on
      May 5, 2007.





On
      February 3, 2006, the Company offered existing warrant holders from the
      $2.0 million, $3.0 million and $2.3 million Private Placements an
      opportunity to exercise their warrants at the reduced price of $0.35 per share.
      On February 27, 2006, the warrant offering expired and the Company received
      proceeds of $592,692 (after expenses) for the exercise of warrants to purchase
      1,864,035 shares of common stock. Between May 31 and June 12, 2006, several
      other existing warrant holders elected to exercise their warrants at the
      contract price identified in their warrant documentation. Proceeds for these
      exercises were $865,452 (after expenses) for the purchase of 1,287,857 shares
      of
      common stock.





On
      April
      27, 2007, the Company offered existing warrant holders an opportunity to
      exercise their warrants at the reduced price of $0.50 per share. If all eligible
      warrant holders were to exercise their warrants at the reduced price, the
      Company would receive proceeds of approximately $4.3 million. The warrant offer
      was originally set to expire on May 25, 2007; however, on May 9, 2007, the
      Company extended this reduced price offer until June 8, 2007. As of May 15,
      2007, the Company amended the offer to grant the warrant holders, who tender
      their warrants, additional shares of Common Stock if the Company enters
      into any agreement for the sale of shares of Common Stock at less than $0.50
      per
      share prior to June 8, 2008. The offer expired on June 8, 2007 without any
      of the warrant holders exercising at the reduced price.





**Options**





The
      Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
      which the Board of Directors has authorized 9,750,000 shares of common stock
      to
      be reserved for future issuance under the Incentive Plan.





F-18




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





The
      following table shows the outstanding options granted under the 2004 Stock
      Incentive Plan:




**Weighted
                Ave****Weighted
                Ave**
            
            **Remaining****Shares**
            
            **Exercise
                Price**
            
            **Contractual
                Term**Outstanding
                at January 1, 2004
            
            
            500,000
            
            $
            1.50
            
            
            -Granted
                in 2005
            
            
            5,450,000
            
            $
            1.50
            
            
            8.2Exercised
                in 2005Forfeited
                or ExpiredOutstanding
                at December 31, 2005
            
            
            5,950,000
            
            $
            1.50
            
            
            8.2Granted
                During the Year Ended December 31, 2006
            
            
            1,350,000
            
            $
            1.28
            
            
            9.0200,000
            
            $
            1.50
            
            
            9.0100,000
            
            $
            0.71
            
            
            9.4Exercised
                During the Year Ended December 31, 2006Forfeited
                or Expired
            
            
            (100,000
            )
            $
            1.28
            
            
            -Outstanding
                at December 31, 2006
            
            
            7,500,000
            
            $
            1.45
            
            
            8.4Granted
                During the Six Months Ended June 30, 2007
            
            
            -
            
            
            -
            
            
            -Exercised
                During the Six Months Ended June 30, 2007
            
            
            -
            
            
            -
            
            
            -Forfeited
                or Expired
            
            
            -
            
            
            -
            
            
            -Outstanding
                at June 30, 2007
            
            
            7,500,000
            
            $
            1.45
            
            
            8.4Exercisable
                at June 30, 2007
            
            
            6,154,250
            
            $
            1.47
            
            
            8.3




**Restricted
      Stock Awards**





On
      November 16, 2006, the Board of Directors approved the grant of 500,000 shares
      of restricted stock to Mr. Roger, pursuant to the terms of the Company's 2004
      Stock Incentive Plan and Mr. Roger's employment agreement. The terms of the
      award were that the shares were to be issued on January 1, 2007 with 166,667
      shares to vest on January 1, 2007, 166,667 shares to vest on January 1, 2008
      and
      166,666 shares to vest on January 1, 2009. The receipt of shares is contingent
      on Mr. Roger remaining employed by the Company on the date of vesting. In 2006,
      there was no FAS 123(R) expense for the grant of restricted stock.


On
        August
        1, 2007, the Company entered into a Separation Agreement with Mr. Roger.
        Mr.
        Roger will receive severance payments and health benefits from the Company
        in
        accordance with his Employment Agreement. Mr. Roger’s Separation Agreement
        includes continuing obligations relating to confidentiality, non-competition
        and
        non-solicitation. The Separation Agreement also provides for a release by
        Mr.
        Roger of any and all claims he may have against the Company. In addition,
        all of
        Mr. Roger’s options vested as of the date of the Separation Agreement and in
        accordance with the 2004 Stock Incentive Plan, Mr. Roger has thirty days
        to
        exercise these options. Finally, 166,667 of the remaining shares of Mr. Roger’s
        restricted stock vest on the date of the Separation Agreement and 166,666
        of the
        remaining shares will vest on July 31, 2008. Mr. Roger agreed not to sell
        or
        transfer these shares until after that date.




On
      May
      14, 2007, the Company entered into an investor relations consulting agreement
      for a term of two months. In exchange for services, the Company will pay
      the consultant a fee of $10,000. In addition, the Company awarded the
      consultant 50,000 shares of restricted stock. In connection with the stock
      award, the Company recognized $27,000 of consulting expense during the
      three and six months ended June 30, 2007.


On
          May
          16, 2007, the Company entered into a second investor relations consulting
          agreement for a term of six months. In exchange for services, the Company
          awarded the consultant 440,000 shares of restricted stock. In connection
          with
          the stock award, the Company recognized $116,600 of the consulting expense
          during the three and six months ended June 30, 2007. Pursuant to the terms
          of the consulting agreement, 120,000 shares and 100,000 shares of the restricted
          stock are earned by the consultant on July 16, 2007 and September 17, 2007,
          respectively. As of June 30, 2007, the restrictions on 220,000 shares issued
          under this contract have lapsed and such shares were
          earned.




The
      following schedule presents shares of common stock issued and outstanding and
      reserved for future issuance as of June 30, 2007:




Common
                Shares Outstanding
            
            
            
            76,680,055Reserved
                For Future IssuanceOptions
                Granted to officers and directors
            
            
            7,500,000Unearned
                common stock issued for compensation
            
            
            333,333Unearned
                common stock issues for commitment shares
            
            
            658,607Warrants
            
            
            10,483,422
            
            
            18,975,362Total
                shares issued and outstanding and reserved for future
                issuance
            
            
            
            
            
            95,655,417




F-19




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**9. Related
      Party Transactions**





A
      company
      controlled by the former Chairman of the Board provides office space, accounting
      and other services to the Company at a cost of approximately $2,500 per month.
      The Company paid $10,284 and $10,284 for the three and six months ended June
      30,
      2006 and paid $8,361, $24,871 (of which approximately $13,800 relates to the
      first six months of 2007) and $204,721 respectively for the three
      and
      six months ended June 30, 2007 and for the period October 14, 2000
      (inception) through June 30, 2007, to the company controlled
      by the former Chairman. The company has accrued $2,500 for services performed
      for the three months ended through June 30, 2007 that are still unpaid.




Included
      in receivables due from related parties at June 30, 2007 is $37,760 which is
      related to travel advances made to employees and directors.





The
      Company has entered into two separate consulting contracts with two shareholders
      of its Brazilian subsidiary for the purpose of providing office rent and
      administrative services and in lieu of employment contracts with these two
      individuals. These two contracts provide support significant to the operation
      of
      the Brazilian subsidiary. The company incurred expenses of $42,607 and $99,708
      for the three and six months ended June 30, 2006, respectively, and $36,334,
      $70,676 and $544,060, for the three and six months ended June 30, 2007 and
      for the period October 14, 2000 (inception) through June 30, 2007,
      respectively.





**10.
      Commitments**





**Operating
      leases**





The
      Company leases office space and certain office equipment under agreements that
      are accounted for as operating leases. As of June 30, 2007, future minimum
      lease
      payments under non-cancelable operating leases expiring through 2008, were
      as
      follows:





Operating
      Leases




2007
            
            $
            50,8252008
            
            
            89,779Total
            
            $
            140,604





Rent
      expense under the leases with unrelated parties was $26,799 and $53,098 for
      the
      three and six months ended June 30, 2006 and was $46,874, $86,070 and $382,545
      respectively for the three and six months ended June 30, 2007 and for the period
      October 14, 2000 (inception) through June 30, 2007.





**11.
      Subsequent Events**





Between
      June 26, 2007 and July 16, 2007, the Company entered into Agreements with five
      European institutional and private investors for
      the
      sale of 6,123,346 shares of the Company’s common stock at a purchase price of
      approximately $0.41 per share in a private placement, for total proceeds of
      $2,517,710, less commissions. As a condition to the enforceability of these
      agreements against the Company, the investors were required to fund the purchase
      price in an escrow account, which funds were received between June 19, 2007
      and
      July 31, 2007.





As
      part
      of the sale, the Company issued warrants to purchase 1,530,827 shares of common
      stock at an exercise price of $0.62 per share during the period of six months
      to
      sixty-six months subsequent to issuance. The warrants expire sixty-six
      months after the date of issuance.





The
      Company is obligated to file a registration statement with the SEC including
      the
      common stock and the shares issuable upon conversion of the warrants within
      90
      days of the closing date. If the registration statement is not filed within
      90
      days, the Company will pay the investors penalties equal to 1.0% of their
      investment amount for the first 30 days and 1.5% of their investment amount
      for
      every 30 days thereafter with a maximum penalty of 8% of the value of the common
      stock as defined in the Agreements. The penalty may be paid in cash or stock
      at
      the option of the Company. The Company will use its reasonable best efforts
      to
      cause such registration statements to become effective within 90 days, or 120
      days if such registration statement is subject to review by the staff of the
      SEC, in each case from the initial filing thereof. All the costs and expense
      incurred in connection with the registration of the common stock and warrants
      will be paid by the Company. The Company held the initial closing for this
      transaction on July 20, 2007.




On
      July
      17, 2007, the Company repurchased 100,000 shares of its common stock from its
      Chief Executive Officer, Alan Rae, for an aggregate purchase price of $40,100.
      The purchase price was $0.401 per share, which was the daily volume weighted
      average for the five trading days prior to the day the Company’s board of
      directors decided on the repurchase.




F-20




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007




**ITEM
      2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
      OPERATION**





**OVERVIEW**





**Business
      Plan**





**Overview**





The
      Company is classified as a development stage company as shown on its unaudited
      consolidated financial statements for the period from inception
      (October 14, 2000) through June 30, 2007.





O2Diesel's
      predecessor, Dynamic Ventures, Inc., was incorporated in the State of Washington
      on April 24, 2000. Dynamic Ventures, Inc. changed its name to O2Diesel
      Corporation effective June 10, 2003, in contemplation of the reverse
      acquisition of AAE Technologies International Plc (“AAE”). On July 15,
      2003, O2Diesel acquired all of the issued and outstanding share capital of
      AAE
      in exchange for 17,847,039 shares of its common stock (the “Offer”). As a result
      of this transaction, the former shareholders of AAE acquired control of the
      combined companies. The acquisition of AAE has been accounted for as a capital
      transaction followed by a recapitalization as AAE was considered to be the
      accounting acquirer. Accordingly, the historical consolidated financial
      statements of AAE are considered to be those of O2Diesel for all periods
      presented.





In
      conjunction with the reverse acquisition, the Company completed a private
      placement of its common stock whereby it issued 3,333,333 shares of common
      stock
      at $1.50 per share. Of the $5.0 million raised, approximately $800,000 was
      used
      to pay the costs of the reverse acquisition and private placement,
      $1.0 million was used to repay a bridge loan that was made in contemplation
      of the transaction, and the balance of $3.2 million was used to fund the
      ongoing developmental activities of the Company.





Subsequent
      to the Offer and during 2003, the Company undertook an effort to raise an
      additional $3.5 million through a follow-on private placement. Pursuant to
      the follow-on financing, the Company issued 1,025,784 shares of its common
      stock
      at $1.50 per share for total proceeds of $1,535,877. The follow-on placement
      was
      closed as of March 31, 2004.




On
      December 29, 2004, the Company consummated a merger (the “Reincorporation
      Merger”) with and into its wholly owned subsidiary, O2Diesel Delaware
      Corporation, a Delaware corporation (“O2Diesel Delaware”), in order to
      reincorporate in the State of Delaware (the “Reincorporation”). The
      Reincorporation Merger was affected pursuant to an Agreement and Plan of Merger
      entered into between the Company and O2Diesel Delaware on December 29,
      2004. The Reincorporation was submitted to a vote of, and approved by, the
      Company's shareholders at its annual meeting held on August 16, 2004. As a
      result of the Reincorporation, the legal domicile of the Company is now
      Delaware. The merger became effective on December 31, 2004.





Since
      July 2003, the Company has raised approximately $33 million for its
      operations.





**Transactions
      During the First Half of 2007**




**ProEco
      Transaction**





On
      January 12, 2007, the Company entered into a share exchange agreement (the
      “Share Exchange Agreement”) with ProEco Energy Company (“ProEco”) and its
      shareholders (“ProEco Shareholders”) to acquire shares equal to 80% of the
      outstanding capital stock of ProEco in exchange for approximately 9.2 million
      shares of the Company's common stock (the “Transaction Shares”) valued at $0.872
      per share for a total purchase price of $8.0 million.





ProEco,
      which has had limited operations to date, is in the process of developing a
      new
      proposed fuel-grade ethanol plant (the “Ethanol Plant”) with planned
      capacity of 100 million gallons per year to be built in two 50 million gallon
      trains (each a “Train”). ProEco Shareholders will receive 60% of the Transaction
      Shares at the time of the closing and will receive the remaining 40% of the
      Transaction Shares in two equal installments upon the completion of construction
      of the first Train (20%) and the commencement of construction of the final
      Train
      (20%). The remaining 40% of the Transaction Shares will be held in escrow until
      the conditions for their release have been met. The parties intend the
      transaction to qualify as a tax-free reorganization under Section 368(a) of
      the
      U.S. Internal Revenue Code of 1986, as amended.





The
      Share
      Exchange Agreement requires ProEco to complete a number of steps toward
      completion of the Ethanol Plant project in order for the closing of the share
      exchange to occur. At the time of the closing, ProEco must have entered into
      a
      definitive engineering, procurement and construction (“EPC”) contract with a
      reputable firm with extensive experience in implementing and completing projects
      similar to the Ethanol Plant project and executed marketing agreements for
      the
      sale of the production of the Ethanol Plant. Under the terms of the share
      exchange agreement, ProEco is responsible for having the Ethanol Plant
      designated as a facility nameplated, or certified, as producing ethanol at
      a
      level of at least 100 million gallons of production a year.




1





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





As
      a
      condition to the closing of the ProEco share exchange, the Company is obligated
      to secure the financing necessary to complete the construction costs to build
      the Ethanol Plant. Accordingly, the Company will be required to raise $120
      to
      $140 million in debt and between $60 and $80 million in equity in two tranches
      in 2007.





Prior
      to
      closing, the Company and the ProEco Shareholders will enter into a stockholder
      agreement that will, among other things, impose restrictions on the transfer
      of
      the Transaction Shares.





The
      Common Stock will be issued to the ProEco shareholders in a transaction that
      will be exempt from the registration requirement pursuant to Section 4(2) of
      the
      Securities Act of 1933 and under Regulation D promulgated under the Securities
      Act.




Under
      the
      terms of the letter of intent for the Share Exchange Agreement, the Company
      agreed to enter into a secured loan agreement with ProEco for the purposes
      of
      financing the purchase options for the land to be used for the Ethanol Plant
      and
      certain engineering and permitting work required for the closing of the ProEco
      share exchange. The annual interest rate on the loan is 7% and the maturity
      date
      of the loan is September 15, 2007. As of June 30, 2007, the Company had advanced
      $735,000 to ProEco under the terms of this agreement.





**$10.0
      million Private Placement**





On
      February 16, 2007, the Company entered into a common stock purchase agreement
      (the “Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
      liability company (“Fusion Capital”). Pursuant to the Purchase Agreement, at the
      Company's discretion, the Company may sell up to $10 million of the Company's
      common stock to Fusion Capital from time to time over a 25-month period. The
      Company has reserved for issuance up to 12,000,000 shares of the Company's
      common stock for sale to Fusion Capital under this agreement. Subject to earlier
      termination at the Company's discretion, Fusion Capital's purchases will occur
      after the SEC has declared effective the registration statement related to
      the
      transaction. The Company has issued to Fusion Capital 805,987 shares of the
      Company's common stock as a commitment fee for entering into the Purchase
      Agreement.





Concurrently
      with entering into the Purchase Agreement, the Company entered into a
      registration rights agreement with Fusion Capital (the “Registration Rights
      Agreement”). Under the Registration Rights Agreement, the Company agreed to file
      a registration statement with the SEC covering the shares that have been issued
      or may be issued to Fusion Capital under the Purchase Agreement. After the
      SEC
      has declared effective the registration statement, generally the Company has
      the
      right but not the obligation from time to time to sell shares of the Company's
      common stock to Fusion Capital in amounts between $100,000 and $1 million
      depending on certain conditions. The Company has the right to control the timing
      and amount of any sales of the Company's shares to Fusion Capital. The purchase
      price of the shares will be determined based upon the market price of the shares
      of common stock without any fixed discount. Fusion Capital does not have the
      right or the obligation to purchase any shares of the Company's common stock
      on
      any business day that the price of the Company's common stock is below either
      $0.50 or $0.60, depending on the transaction size of the purchase. The agreement
      may be terminated by the Company at any time at its discretion without any
      cost
      to the Company.





During
      the quarter ended June 30, 2007, the Company executed five separate transactions
      under this agreement, selling a total of 970,994 shares of common stock at
      an
      average price of $0.515 per share for total proceeds of $500,000.




**Warrants**





On
      April
      27, 2007, the Company offered existing warrant holders an opportunity to
      exercise their warrants at the reduced price of $0.50 per share. If all eligible
      warrant holders were to exercise their warrants at the reduced price, the
      Company would receive proceeds of approximately $4.3 million. The warrant offer
      was originally set to expire on May 25, 2007, however on May 9, 2007, the
      Company extended this reduced price offer until June 8, 2007. As of May 15,
      2007, the Company amended the offer to grant the warrant holders, who tender
      their warrants, additional shares of Common Stock if the Company enters
      into any agreement for the sale of shares of Common Stock at less than $0.50
      per
      share prior to June 8, 2008. The offer expired on June 8, 2007, without any
      of the warrant holders exercising at the reduced price.





**Listing
      of Common Stock on AMEX**




On
      June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
      an application to list 46,518,898 shares of our common stock under the symbol
      OTD. Subsequent to this date, the Exchange has approved additional applications
      to list 68,378,483 more shares of our common stock so that the total number
      of
      shares approved for listing is 114,897,381. Our shares began to trade on the
      Exchange on July 1, 2004.




The
      Company's audited consolidated financial statements for the year ended
      December 31, 2006, were prepared on a going concern basis, which
      contemplates the realization of assets and the settlement of liabilities and
      commitments in the normal course of business. Our independent registered public
      accounting firm included an explanatory paragraph in their report on the
      December 31, 2006




2





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





audited
      consolidated financial statements to highlight that the Company's accumulated
      losses and lack of available working capital raised substantial doubt about
      the
      Company's ability to continue as a going concern.





The
      Company's unaudited consolidated financial statements for the three and six
      months ended June 30, 2007, have been prepared on a going concern basis, which
      contemplates the realization of assets and the settlement of liabilities and
      commitments in the normal course of business. At June 30, 2007, the Company
      had
      working capital of $3,320,776 and had accumulated losses of
      $37,571,565.





Further,
      the Company was notified in December 2004 by the AMEX that it was no longer
      in compliance with the listing standards of the Exchange because it lacked
      the
      requisite amount of stockholders' equity. AMEX requires that minimum levels
      of
      stockholders' equity be maintained. O2Diesel was not in compliance because
      its
      stockholders' equity had dropped below the required minimums, and
      it
      had experienced continuing losses for the past four years. In order to return
      to
      full compliance, O2Diesel must have stockholders' equity of $6.0 million by
      June 2006 and maintain this level going forward.





In
      accordance with the procedures of the Exchange, we filed a plan (“Plan”) with it
      to demonstrate the steps we would take to return to full compliance. On
      February 15, 2005, the AMEX notified us that it had accepted our Plan, and
      that we would be given until June 2006 in which to regain compliance with
      the Exchange's listing rules. To achieve that level of stockholders' equity,
      we
      anticipated having to raise a total of approximately $10.0 million in new
      equity during 2005. In December 2005, the Company determined that it could
      not meet certain conditions of the Plan and met with representatives of the
      AMEX
      to discuss the need to develop an amended plan to demonstrate how the Company
      would be in compliance by June 2006. During 2006, as part of its efforts to
      meet these requirements, the Company closed an offer to existing warrant holders
      to exercise their warrants at a reduced price for proceeds of approximately
      $1.5
      million (after expenses) and three private placements totaling
      $7.5 million.





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company had regained compliance with AMEX listing requirements. At December
      31,
      2006, the Company was in compliance with AMEX listing requirements, but for
      period ended March 31, 2007, the Company was not able to meet the listing
      requirements. On June 29, 2007, the Company was notified by AMEX that it was
      not
      in compliance with the listing standards of the Exchange because it lacked
      the
      requisite amount of stockholders' equity. The Company was asked to submit a
      plan
      by July 27, 2007 advising AMEX of actions the Company would be taking to bring
      it into compliance with the continued listing standards by December 29, 2008.





On
      July
      27, 2007, the Company filed a plan with the Exchange to describe the steps
      to be
      taken to return to full compliance. As we describe later in this section, the
      Company has entered into a common stock purchase agreement to raise up to $10
      million in new equity in 2007. Also, the Company announced a private placement
      in which we raised an additional $2.52 million, which is described under
“Subsequent Changes in Securities”. The Company intends to raise up to an
      additional $80 million in new equity in conjunction with the acquisition of
      ProEco. We believe these actions will enable us to meet or exceed the equity
      requirements of the Exchange.





If
      the
      Company were to fail to return to full compliance with the Exchange's listing
      standards, the AMEX would likely initiate procedures to de-list the Company's
      common stock. If the Company's common stock were to be de-listed by the AMEX,
      its shares would continue to be traded as a bulletin board stock.





The
      consolidated financial statements in this report do not include any adjustments
      to reflect other anticipated private placements or the possible future effects
      on the recoverability and classification of assets or the amounts and
      classification of liabilities that may result should management be unsuccessful
      in obtaining financing on terms acceptable to the Company.




3




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007


**Operations**





During
      the second quarter of 2007, we continued our efforts to generate sales to our
      targeted fleet customers in North America and Brazil, as well as our efforts
      to
      develop targeted demonstrations in Europe. At the same time, the Company
      continued its relationship with its Asian partner, Energenics Pte Ltd
      (“Energenics”).





United
      States and Canada:





Our
      focus
      for the U.S. and Canada has been to target key geographical areas and specific
      diesel markets based upon:





**Ø**
            
            Current
                and projected quantity of diesel fuel consumption;**Ø**
            
            High-population
                centers under strict air quality regulations;**Ø**
            
            Municipal
                transit and school bus fleets with an emphasis on public policy and
                a
                positive environmental image;**Ø**
            
            Large
                concentrations of urban-based, centrally fueled fleets of trucks
                and
                buses;**Ø**
            
            Off-road
                construction equipment;**Ø**
            
            Diesel
                equipment used by port facilities and large-scale mining operations;
                and**Ø**
            
            Military
                installations in non-combat
                vehicles.




In
      the
      U.S., O2Diesel's second quarter sales and marketing efforts for fleet sales
      continued to be focused in the state of California and in the Midwest. In
      Canada, we intend to focus our efforts on the country's large population centers
      in the Eastern and Western provinces, but until we have commercialized our
      technology in the U.S., no significant resources will be devoted to
      Canada.





In
      the
      second quarter of 2007, the Company maintained commercial activities at the
      Port
      of Long Beach and continued to pursue additional opportunities in this market
      segment. The Company received a letter from the Port which recommends the use
      of
      O2DieselTM in any of the existing centrally fueled fleets throughout the Port as
      part of its Green Port Policy and its Clean Air Action Plan. The Company also
      announced that the U.S. Air Force had approved the expansion of its successful
      test demonstration at a USAF base in Nevada, both in the number of vehicles
      to
      be used and the length of time the demonstration will now run.





The
      Company had previously concluded successful test demonstrations in Clark County,
      Nevada which was devoted to documenting the reduced emission benefits of
      O2DieselTM over a range of temperatures and engine types as well as
      demonstrations at a large coal mining operation in Wyoming and a municipal
      waste
      fleet in California.





We
      also
      continued to devote resources to our CityHomeTM marketing program as a means of
      developing sales and documenting operating and performance data. CityHomeTM is a
      marketing and sales initiative directed at municipal transit agencies across
      the
      United States as an opportunity to improve air quality in urban locations.
      This
      program stresses the environmental benefits of our fuel and is designed to
      allow
      municipal transit authorities to convert their fleets to O2DieselTM without
      having to pay the higher costs of our fuel.





Through
      an innovative cost sharing concept with companies that wish to be good corporate
      citizens (sponsors), we have designed a program which permits the municipalities
      to purchase our fuel at costs which are the same as what they pay for regular
      diesel fuel. Corporate sponsors, generally with a national or international
      presence, will pay sponsorship fees to O2Diesel to take part in a clean air
      program for one or more of the communities participating in a CityHomeTM program.
      In return for sponsorship payments, each sponsor will be given access to
      currently unused advertising space on buses and other advertising assets owned
      by the municipality. Sponsorship fees will become additional revenue for us
      and
      will be recognized as such when the related advertising is displayed and all
      other criteria for revenue recognition have been met. Costs that are intended
      to
      be supported by the sponsorship fees are recorded separately in the related
      expense line in our statement of operations. With regard to the advertising
      space, since the CityHomeTM program is still in a relatively undeveloped stage
      and since we have been unable to assess the fair market value of the advertising
      space received, we assign no value to the space at the time of the receipt.
      We
      are recognizing the value associated with the advertising space when we enter
      into a contractual arrangement with a third party. The Company will consider
      assigning a fair value to the advertising space received at the time of the
      initial sale when such fair value is more readily determinable, based upon
      a
      history of cash transactions.




4




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007




In
      the
      second quarter of 2007, we had CityHomeTM installations with several municipal
      bus fleets, as well as a Midwestern operator of both school and tour bus fleets
      and small school bus fleets in Chicago and South Dakota. To date, we have used
      this initiative as a useful component of our test/demonstration strategy and
      have been successful in attracting fuel distributors to work with us in getting
      this initiative started. However, while we have received sponsorship funding
      for
      our current CityHomeTM programs, several fleet demonstrations executed under this
      program have continued to require significant financial support from the
      Company. As a result, we have limited new CityHomeTM programs to instances where
      we are assured of a level of sponsorship funding needed to cover all expenses
      of
      the demonstration. The Company’s future involvement with the CityHomeTM program
      has thus been reduced only to programs that can be considered to be cost
      neutral. During the second quarter of 2007, we concluded our demonstrations
      in
      Springfield, Illinois and Des Moines, Iowa and continued running two CityHomeTM
fleets in Johnson County, Kansas and Lincoln, Nebraska.





We
      have
      also continued to establish and improve the logistics network required for
      the
      delivery of O2DieselTM to fleet and CityHomeTM customers during the second
      quarter. These efforts have centered on developing strategic relationships
      with
      ethanol producers and distributors in order to improve both quality consistency
      and price stability. As of June 30, 2007, the Company had supply agreements
      in
      place with two ethanol industry groups to obtain a supply of limited amounts
      of
      ethanol at preferential pricing for our Midwestern customers.





In
      addition, the Company continued to support its efforts to acquire an 80%
      ownership share in ProEco, which is planning to build a 100 million gallon
      ethanol plant in South Dakota. Once this acquisition has closed and the plant
      is
      operational, it is expected that this facility will provide a reliable source
      of
      high quality, competitively priced ethanol for the Company to use in developing
      the U.S. market. During the second quarter of 2007, the Company expanded its
      support of ProEco to obtain options for land purchases, the submission of
      permits for construction , the negotiation of an EPC contract, the negotiation
      of supply and transportation agreements and the development of marketing
      agreements for sale of the ethanol to be produced at this facility.





We
      are
      continuing a series of product tests and demonstrations that relate directly
      to
      obtaining regulatory approval for O2DieselTM and which are designed to meet the
      needs of our targeted customers. During the quarter ended June 30, 2007, the
      Company continued its efforts to register O2DieselTM fuel with the EPA and
      continued to conduct a revised series of tests to qualify O2DieselTM as a
      California Diesel Emissions Control Strategy both as a stand alone fuel and
      in
      conjunction with various exhaust after treatment devices, such as both direct
      oxidation catalysts (DOC's) and Diesel Particulate Filters (DPF's).





In
      addition, we continued to develop a revised ballot for incorporation of
      ethanol-diesel fuel as an American Society for Testing and Materials (ASTM)
      specification. This revision is based on the results of the initial voting
      on
      the original ballot submitted in December 2006. A member of the Company serves
      as the chairman of the subcommittee tasked with revising this ballot and it
      is
      expected to be resubmitted during the second half of 2007 so that it can be
      discussed and voted on during the December 2007 ASTM international meeting.





Finally,
      during the second quarter of 2007 we continued to develop contract proposals
      for
      submission to the Department of Energy and the Department of Defense to utilize
      the $2.0 million of available appropriations received in prior years. These
      appropriations wre awarded for the purpose of continued testing and verification
      of O2DieselTM, including the requirements of both DECS and the U.S. military.





Brazil:





In
      Brazil, O2Diesel is targeting customers on a very focused basis. In general,
      these will be miller fleets (sugar and ethanol producers), municipal bus and
      other fleets, and to a lesser extent centrally fueled truck fleets. The roll
      out
      of our product has been much slower than planned. Obtaining government approvals
      and gaining market awareness has taken longer than we anticipated. In response
      to these matters, we have made a decision to reduce our overhead and our
      marketing plans until we have a solid base of customers in Brazil. During the
      second quarter of 2007, we continued our support of one test fleet and entered
      into negotiations with a municipal bus fleet in Curitiba.





In
      April,
      2007, we announced the appointment of Fair Energy, S.A. as our distributor
      for
      several new markets in Central and South America. Demonstrations programs in
      Columbia, Paraguay and Bolivia are targeted by the Company over the next several
      quarters.





Europe:





During
      the second quarter of 2007, we pursued discussions and initiatives in Europe
      to
      test our fuel and to determine the market size and regulatory hurdles to be
      overcome to gain wider acceptance of our fuel in Europe. As of June 30, 2007,
      the Company had identified two municipal transit fleets, a waste fleet and
      a
      port facility that were interested in evaluating O2DieselTM fuel during these
      demonstrations. The Company recently announced that it had received regulatory
      approval in France to begin testing O2DieselTM in a large transit system in
      Angouleme in the Bordeaux region of France. We expect these activities to
      develop into additional demonstration programs over the next two
      quarters.




5




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





Asia:





In
      Asia,
      the company that serves as our exclusive distribution agent announced that
      it
      had concluded a successful trial demonstration of the fuel and we commenced
      supplying the first 2,500 buses of a large municipal fleet in Karnataka, India.
      This expansion is expected to continue during the third and fourth quarters
      of
      2007.





Technical
      and Logistical Issues





Significant
      technical and logistical issues continued to affect our ability to generate
      sales in the second quarter of 2007. While we have made substantial progress
      in
      addressing these challenges over the course of the year, they have continued
      to
      impede our efforts to commercialize O2DieselTM fuel. In general, these challenges
      fall into the following categories: (1) logistics of delivering and dispensing
      O2DieselTM, (2) obtaining consistent high quality fuel grade ethanol at
      competitive prices and (3) acquiring regulatory approval and an industry
      accepted specification for our “e-diesel” (ethanol-diesel) fuel. O2Diesel has
      devised several strategies to meet these challenges and has undertaken a variety
      of activities to overcome them and to position O2DieselTM as a premium
      clean-burning fuel.





Logistics





Under
      the
      first element of our strategy, we have signed distribution agreements with
      fourteen jobbers, who in turn have centrally fueled fleets as their customers.
      We sell additive to these jobbers and assist them in purchasing ethanol by
      either locating ethanol suppliers or purchasing and reselling ethanol to them.
      However, we will only purchase ethanol as an accommodation to a jobber, because
      we do not wish to tie-up our limited working capital to finance the purchases
      of
      ethanol. The jobbers blend our additive and ethanol with diesel fuel and then
      sell O2DieselTM to their customers. O2Diesel's sales force and technical staff
      work jointly with each jobber and the jobber's customers to assist in the
      transition from the use of regular diesel fuel to O2DieselTM. A key part of
      working with each jobber and its customers is to provide safety and training
      materials covering the use of the fuel. In addition, O2Diesel's technical staff
      works closely with each customer in the process of purchasing and installing
      flame arrestors and other devices for customer vehicles and storage facilities.
      In some cases, we are responsible for sourcing and installing these devices
      while, in other cases, our technical staff will only have an oversight role.
      Finally, our technical staff will work with the customer to insure that its
      storage facilities are clean and are compatible for storing and dispensing
      O2DieselTM.





Our
      sales
      strategy is to market and sell O2DieselTM directly to companies, governmental
      port facilities and others that operate large centrally fueled fleets. These
      customers may include large truck and bus fleets, construction municipalities,
      and mining companies as well as port cargo handling facilities and agricultural
      users. To date, these customers have only included centrally fueled truck fleets
      and cargo handling facilities at a major port. In these transactions, the
      Company will maintain a similar working relationship with the customer's
      blending facilities and staff as it does with third party jobbers.





Secondly,
      as part of the process by which O2DieselTM was approved for sale in California,
      the California Air Resources Board set a number of conditions that we must
      adhere to on an ongoing basis. One of the conditions is that all storage tanks
      in which O2DieselTM is stored and all vehicles that use the fuel must be fitted
      with devices known as flame arrestors. Flame arrestors are safety devices which
      are intended to prevent a fire in case a spark or other type of ignition might
      inadvertently enter the fill inlet of a fuel tank. Imposing this requirement
      proved to be a serious issue prior to 2006, and was a serious challenge to
      our
      ability to effectively commercialize our technology in the U.S. Even though
      flame arrestor technology has been used for many years in other applications,
      flame arrestors in the required sizes and designs were not yet available as
      an
“off the shelf item” for use with O2DieselTM during this time. At the beginning
      of 2007, the flame arrestor challenge had been largely resolved for the vehicles
      within O2Diesel’s target markets.





A
      third
      concern we have relates to the logistics and storage of O2DieselTM for fleets and
      other diesel equipment that may use the fuel. In particular, it is very
      important that storage tanks be cleaned prior to the introduction of O2DieselTM
into the customer's refueling station. We have made important strides in working
      with customers to insure that their storage facilities are compatible with
      O2DieselTM and have now included this step as a critical component of our
      implementation planning process.





The
      Company has taken several steps prior to 2007 to overcome these problems and
      to
      support the introduction of O2DieselTM fuel to new customer opportunities. First,
      we assembled our knowledge and documentation regarding the design requirements
      of flame arrestors in the market areas we served and developed a catalogue
      of
      flame arrestors and parts that can be used for a wide variety of engine/vehicle
      types and customer applications. Second, we developed a checklist of procedures
      to be used by our technicians (in conjunction with our customer) that enabled
      our technicians to prepare a comprehensive fleet profile of hardware
      requirements, tank cleaning procedures and the time required to perform the
      work
      necessary to bring a fleet on-line. Third, we have identified several equipment
      vendors who we plan to work with so that needed equipment can be delivered
      to
      customer locations quickly and at competitive prices. Fourth, we have developed
      a training program that will enable our technicians to teach our customer's
      fleet




6




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





maintenance
      staff about handling and storing O2DieselTM fuel, fleet modification and
      maintenance issues that can be expected. Finally, we have developed a modest
      parts inventory at our laboratory facility so that in the event of an emergency,
      required parts can be supplied to our customers.





Our
      present planning methodology is based on a mutually agreed upon implementation
      time frame that requires the project to be a joint effort utilizing the
      customer's employees and identifies the timing and costs that the customer
      can
      expect. During 2005 and 2006, we continued the research and development efforts
      begun in 2004 to design and to identify flame arrestors, adaptors and other
      equipment for vehicles that use O2DieselTM. Where required, these devices have
      undergone and passed tests to insure that they are capable of complying with
      all
      required specifications. In addition, we have learned that certain engines
      require the fitting of a primer pump to insure that the vehicle starts and
      runs
      properly in hot weather. These devices are simple and readily available and
      the
      costs are known, but the necessity of adding these devices to certain vehicles
      has, in some cases, increased our costs as well as the time required to
      transition a fleet from using regular diesel fuel to the use of O2DieselTM.
      Lastly, in some buses, we have had to install safety fueling devices in the
      fuel
      inlet that serve the function of flame arrestors, but are generally more
      expensive. These particular devices are readily available in the market. To
      support our implementation efforts, we commissioned a third party engineering
      consulting firm to review our written safety training procedures as well as
      to
      conduct on-site reviews of four of our customer locations in order to evaluate
      the adequacy of the training and the quality of safety procedure implementation.
      The ensuing report from the consultant indicated that our safety program
      requirements were well conceived and were being followed quite closely at all
      locations. Additional safety procedures to enhance this program are currently
      being evaluated.





In
      the
      past, these issues have led to greater lead times than expected to convert
      fleets from using regular diesel to O2DieselTM. In fact, we have seen that the
      time it takes to do the conversion work can be the most important factor in
      bringing on more customers to use our fuel. As a means of mitigating the time
      required for converting a fleet, we have sought to have our customers complete
      much of this work under our direction. However, this policy is dependent upon
      obtaining an agreement from the customer to do the work. The actual time
      required to convert a fleet to use O2DieselTM may be further limited by the
      availability of the customers' vehicles to be in one place long enough to effect
      the required changes. In some cases for safety, insurance or union reasons,
      customers will require that they complete all of the work necessary for their
      vehicles and diesel powered equipment to use O2DieselTM, as well as arranging to
      insure that their storage and dispensing facilities are compatible with the
      use
      of the fuel.





The
      Company has made significant progress in addressing these key logistical issues
      over the past several years and we now feel that we can provide the necessary
      support to our customers both before and during implementation of our fuel
      in
      their fleets. The Company anticipates that the work achieved prior to 2007
      with
      all of these implementation factors will allow us to avoid the costs and delays
      we experienced in the past.





Ethanol
      Supply





Our
      experience has demonstrated that it is important to carefully select ethanol
      suppliers because there is a wide range of fuel grade ethanol in the
      marketplace. It is critical that the ethanol component of O2DieselTM be of a
      consistently high quality and that it meet certain other specifications.
      Selection of ethanol suppliers and creating a relationship with those that
      can
      provide the quality of product we require is a significant need, and is a task
      that we will devote more time to during the remainder of 2007. We are currently
      working closely with the industry to identify ethanol suppliers who meet
      our criteria. As of June 30, 2007, we had continued to maintain contracts with
      two ethanol industry groups to provide a supply of limited amounts of ethanol
      at
      preferential pricing for our Midwestern customers.





In
      order
      to insure fuel quality, we have developed a quality control function that
      constantly tests the ethanol used by all customers. In addition, we have learned
      that it is necessary to test the quality of diesel blended with our additive
      and
      ethanol. Establishing our own laboratory facility has been a significant help
      to
      us in developing quality control standards, and for carrying out the tests
      that
      are necessary in preparing a fleet for conversion to use O2DieselTM.
      Additionally, the Company has installed several testing devices in the field
      so
      that samples can be evaluated more efficiently than with a centralized
      laboratory alone. None of these tests are time consuming or technically
      difficult, but they are critical to ensuring that our product functions as
      intended. As we gain more experience, it may not be necessary to conduct the
      level and frequency of tests that we expect to do over this coming
      year.





The
      Company has seen that even with a reliable supplier, the price of ethanol can
      be
      volatile as a result of a number of factors, such as the overall supply and
      demand, the level of government support, and the availability and price of
      competing products. For example, many petroleum refiners have recently replaced
      methyl tertiary butyl ether (MBTE) in gasoline with ethanol during the second
      quarter of 2006. The replacement of this ingredient in gasoline has caused
      the
      demand for ethanol to increase dramatically, with a corresponding increase
      in
      its price. A benefit of this phenomenon has been to increase the availability
      of
      ethanol at petroleum terminals when compared to the recent past. However, the
      rise in the cost of ethanol has made the price of O2DieselTM fuel increase in
      relation to conventional diesel fuel during the first half of 2007. In the
      short
      term, it is the Company's strategy to contract with third parties to help
      control the costs of ethanol and reduce short-term exposure to price
      fluctuations by continuing our contracts with the ethanol industry groups for
      limited amounts of ethanol at preferred prices.




7




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





In
      the
      longer term, the Company has seen the clear advantage represented by
      partnerships with distributors who have access to high quality, price
      competitive ethanol in the local market. In this regard, our partnership with
      Energenics in Asia, Abengoa in Europe and Fair Energy in South America have
      provided significant support to our efforts to blend O2DieselTM fuel at prices
      that are competitive with conventional diesel fuel in the markets we are
      entering. For this same reason, we have decided to acquire ProEco Energy so
      that
      we can have a similar quality and price advantage with our ethanol supply in
      the
      United States.





As
      a
      result of these efforts, the Company believes it has both an interim and
      long-term strategic opportunity to achieve a supply of high quality, price
      competitive ethanol among its key markets,





Regulatory
      Approval





As
      outlined in “Research and Development”, the Company must obtain regulatory
      approvals at a number of levels in order to be able to sell commercial
      quantities of O2DieselTM in the United States. These approvals involve the
      Environmental Protection Agency (EPA) at the federal level, the California
      Air
      Resources Board (CARB) at the state level and the American Society for Testing
      Materials (ASTM) at both a military and industry level. The process of acquiring
      these approvals requires significant testing for emissions, impact to the
      environment, safety, performance and engine warranty considerations among a
      broad range of engine types and ages. In some cases, existing regulations or
      the
      interpretation of the requirements to meet these regulations can change over
      the
      testing periods, either because of new legislation, additional technical data
      in
      the industry or the agencies’ understanding of the technology they are
      evaluating. Such changes can add significant time to completing the required
      testing, either through changes in protocols or additional tests to be
      performed. While the Company has achieved important verification of its
      technology among these various agencies, the time and expense required to obtain
      final approval remains quite lengthy. Our experience in Europe has been similar,
      indicating that final regulatory approval here will also take additional time.
      In Asia and South America, similar approvals need to be obtained, but we are
      able to rely on our strategic partners in these areas to assist us in obtaining
      the appropriate regulatory permission to sell our fuel.





The
      technical challenges over this past year have presented significant hurdles
      to
      commercializing our technology. In most cases, we have overcome these obstacles
      by the application of technical resources, payments to support our customers
      and
      a high level of customer service. All of this has been time-consuming and has
      slowed our ability to bring our product to market. But it has also created
      a
      base of knowledge which is helpful as we continue our efforts to commercialize
      our technology. We have been encouraged by the fact that among our customers,
      we
      have a municipal bus fleet and a port facility that have been successfully
      utilizing the fuel for more than one year. Even though we have gained a
      significant amount of technical knowledge, we will continue to refine our
      efforts in this area in order to improve our ability to bring on greater numbers
      of customers and to better predict the cost and timing of the work required
      to
      have fleets conform to the requirements of using our product.





**Second
      Quarter Summary**





Operating
      results during the six month period ended June 30, 2007 showed mixed
      results in comparison to those during the six month period ended June 30, 2006.
      Sales improved significantly from $68,500 (six months ended June 30, 2006)
      to
      $181,000 (six months ended June 30, 2007) due in large part to the second major
      shipment of additive to our Asian distributor. Cost of goods increased by
      $91,000 reflecting the increased sales activity as the gross operating margin
      percentage was relatively flat compared to the six months ended June 30, 2006.
      Selling and marketing expenses for the period ended June 30, 2007 were nearly
      $145,000 higher than during the period ended June 30, 2006, mostly reflecting
      the use of consultants at the Spanish subsidiary which was in start up mode
      at
      this time last year. Product testing and government grant expenses (net) in
      the
      six months ended June 30, 2007 were approximately $30,000 higher than in the
      period ended June 30, 2006 due to an increase in research and development costs
      associated with the Spanish subsidiary. General and administrative expenses
      for
      the six months ended June 30, 2007 were approximately $600,000 higher than
      for
      the six months ended June 30, 2006 due to the use of additional accounting
      consultants of $223,000, costs of investor relation firms of $231,000, and
      an
      officer’s restricted stock award of $137,000 in comparison to the period ended
      June 30, 2006. In addition, general and administrative costs reflected an
      increase of $47,000 in the recognition of share-based compensation expense
      required by SFAS 123(R) versus the same period in 2006.





**Cash
      Requirements, Liquidity and Risk Factors**





Based
      on
      our projected level of expenses and the cash on hand as shown on our
      consolidated balance sheet at June 30, 2007, we will need to raise additional
      funds in 2007 to allow us to execute our business plan and to be in compliance
      with the AMEX’s listing standards.




8




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





To
      date,
      we have not had any bank trade facilities, except an overdraft line in the
      U.K.
      used to meet operating needs and a small vehicle loan, both of which have been
      paid and cancelled prior to 2007. However, if the Company achieves significant
      sales, we plan to apply for trading lines with banks in the U.S. and other
      countries as a means to finance our working capital needs. In the second quarter
      of 2007, the Company continued to have favorable trade terms with its supplier,
      Cognis Deutschland GmbH (“Cognis”) for the supply of additive.





AMEX
      requires that minimum levels of stockholders' equity be maintained. In December,
      2004, the Company was notified that it was not in compliance because its
      stockholders’ equity had dropped below the required minimums, and it had
      experienced continuing losses for the past four years. In order to return to
      full compliance, O2Diesel needed to have stockholders' equity of
      $6.0 million by June 2006 and maintain this level going forward. In
      accordance with the procedures of the AMEX, we filed a plan (“Plan”) with it to
      demonstrate the steps we will take to return to full compliance. On
      February 15, 2005, the AMEX notified us that it had accepted our Plan, and
      that we would be given until June 2006 in which to regain compliance with the
      AMEX's listing rules. To achieve that level of stockholders' equity, we
      anticipated having to raise a total of approximately $10.0 million in new
      equity during 2005. In December 2005, the Company determined that it could
      not
      meet certain conditions of the plan and met with representatives of the AMEX
      to
      discuss the need to develop an amended plan to demonstrate how the Company
      would
      be in compliance by June 2006. During 2006, as part of its efforts to meet
      these requirements, the Company closed an offer to existing warrant holders
      to
      exercise their warrants at a reduced price for proceeds of approximately $1.5
      million (after expenses) and three private placements totaling $7.5
      million.





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company had regained compliance with AMEX listing requirements. At December
      31,
      2006, the Company was in compliance with AMEX listing requirements, but as
      of
      March 31, 2007, the Company was not able to meet the listing requirements.
      On
      June 29, 2007, the Company was notified by AMEX that it was not in compliance
      with the listing standards of the Exchange because it lacked the requisite
      amount of stockholders' equity. The Company was asked to submit a plan by July
      27, 2007 advising AMEX of actions the Company would be taking to bring it into
      compliance with the continued listing standards by December 29,
      2008.





On
      July
      27, 2007, the Company filed a plan with the Exchange to describe the steps
      to be
      taken to return to full compliance. The Company has entered into a common stock
      purchase agreement to raise up to $10 million in new equity in 2007. Also,
      the
      Company announced a private placement in which we raised an additional $2.52
      million, which is also described under “Subsequent Changes
      in
      Securities”.
      The Company
      intends to raise up to an additional $80 million in new equity in conjunction
      with the acquisition of ProEco. We believe these actions will enable us to
      meet
      or exceed the equity requirements of the Exchange.





As
      a
      result of the lack of a sales history for our products, we do not have
      sufficient historical financial data for any periods on which to accurately
      forecast future revenues or operating expenses in connection with achieving
      such
      revenues. As such, we are not able to project with certainty the additional
      funds that may need to be raised. In 2006, we raised new equity of approximately
      $9.0 million, before payment of expenses. In 2007, the Company negotiated
      new equity up to $12.2 million. As stated previously, even with the fund raising
      completed in 2006 and early 2007, we will need to raise additional equity during
      this year. We continue to hold discussions with a number of potential investors
      and work with a professional investor relations service company to assist with
      these efforts. In connection with our efforts to attract new investment, there
      can be no assurance that we will be successful in doing so. Nor can there be
      any
      assurance that the Company will generate sales and sponsorship fees followed
      by
      the collection of cash to offset our operating expenses.





As
      shown
      in the consolidated statements of operations contained in this report, we have
      generated only $15,035 and $180,998 in sales and had sponsorship income of
      $3,750 and $19,500 associated with the CityHomeTM programs for the three and six
      months ended June 30, 2007. As of the date of this report, we have only minimal
      orders on hand for either O2D05 or O2DieselTM, other than our supply requirements
      for Energenics. Lastly, there can be no assurance that actual events will not
      differ from those anticipated, or that general economic conditions may not
      vary
      significantly in ways that could negatively impact our operations and cash
      position.





**Research
      & Development**





The
      Company has 109 patent applications covering eight different fuel and additive
      inventions relating to proprietary products registered with the international
      WIPO (PCT) Registration System. Four inventions currently have patents granted
      in a total of 32 countries in Europe, North America, Central America and Asia.
      An additional twelve applications relating to these inventions are pending.
      The
      other four inventions are either undergoing examination at the national level
      or
      are about to do so in various countries. If successful, these other four
      inventions could add up to 65 additional granted patents over the next two
      years. During this period, O2Diesel's intellectual property rights over its
      additive products are protected through its registration with the WIPO (PCT)
      Registration System and its pending national patent applications.





As
      part
      of our cooperation agreement with Cognis, we, along with Cognis, are the joint
      owners of all patents covering both the use and composition of O2D05. All legal
      costs associated with preparing, filing and administering the jointly owned
      patents are shared equally





9


O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





by
      the
      Company and Cognis. We also have a number of patents that have been issued
      that
      relate to the predecessor technology of O2D05. As a strategic measure, we
      continue to fund all costs necessary to maintain some of these patents. O2Diesel
      is the sole owner of these latter patents, which in general cover the use and
      composition of its prior generation technology.





We
      have
      registered a trademark in the U.S. and the European Union for a mark which
      includes the words and numbers O2DieselTM as well as a figurative logo of the
      words. We also registered trademarks for “CityHome” (and design) in eight
      classes of goods and services, “TODAY'S CLEAN AIR SOLUTION TOMORROW'S BRIGHTER
      FUTURE” and “CITYHO2ME”, each covering one class of goods and
      services.





The
      Company has incurred substantial costs in carrying out tests to demonstrate
      that
      the use of our product will enable customers to comply with environmental laws
      and regulations. As of June 30, 2007, we incurred external expenses of $454,442
      during 2007 in the U.S. in connection with governmental sponsored projects
      and
      tests. Most of the costs incurred in these government test programs will
      be reimbursed by appropriations from the U.S. Departments of Energy and
      Defense.





At
      the
      end of the second quarter of 2007, we had government test programs in progress
      with total remaining costs to complete of approximately $1.1 million. Under
      these programs, a wide array of engine tests and product demonstrations are
      to
      be conducted to further prove the emissions benefits of O2DieselTM and to show
      that the fuel performs well in specific applications.





Included
      in the foregoing programs are a number of emissions validation and verification
      projects as well as fleet demonstrations. All of the verification and validation
      programs are complicated and may take considerable time to complete. Finishing
      the protocols to allow O2DieselTM to be classified as a Diesel Emission Control
      Strategy fuel by the California Air Resources Board and registering the fuel
      with the EPA so that the emissions benefits can be quantified in their testing
      protocols are critical to our success. At this point, we are at an early stage
      so that it is not possible to predict when this work will be completed or if
      we
      will obtain the desired results once it is completed. We are also working with
      the military on a procurement specification for O2DieselTM alone or in
      combination with up to 20% biodiesel which should be completed this year. Based
      on the government funding in place, we believe that approximately 80% of the
      costs to conduct these tests and field demonstrations may be funded by
      appropriations from the U.S. Departments of Energy and Defense.





We
      have
      generated several successes in our fleet demonstration projects. These fleets
      are key to developing the no harm field experience necessary to demonstrate
      the
      commercial value of the fuel. Based upon its positive experience at Nellis
      Air
      Force base, the U.S. Air Force has expanded product demonstrations in Nevada
      to
      test O2DieselTM with 20% biodiesel in twice the number of non-tactical military
      vehicles that were used in the original test fleet. O2DieselTM is also conducting
      demonstrations with a number of school bus and transit agencies. In order to
      demonstrate the fuel’s capability in a broad array of conditions, O2DieselTM and
      O2DieselTM blended with up to 20% biodiesel are in fleets containing assorted
      engine types and uses and facing various weather conditions. We are continuing
      to refine our additive formulations in order to reduce their costs and increase
      their performance. In this regard, we have registered a second additive package
      with the Environmental Protection Agency that accomplishes both goals.
      Additionally, we have formulated and field tested cold weather and detergent
      containing fuel formulations which are working as intended. We expect this
      work
      to continue in 2007.





**Employees**





As
      of
      June 30, 2007, O2Diesel had seventeen full-time employees of which sixteen
      are
      in the U.S. and one is in Europe. We had one part-time employee. Currently,
      we
      rely on consultants to assist in commercializing our technology and to help
      us
      in key technical areas. At present, we employ seven consultants in the U.S.:
      three in marketing and business development; one laboratory technician, one
      chemist and two in regulatory affairs. The Company has entered into separate
      consulting contracts with two shareholders of its Brazilian subsidiary for
      the
      purpose of providing office rent and administrative services and in lieu of
      employment contracts with these two individuals. In Europe, we employ two
      consultants, one for general management and business development and one for
      regulatory affairs.





We
      will
      add new personnel in 2007 based on the pace of our commercialization. Under
      our
      business plan, we do not see the need to add employees in the U.S. or Brazil,
      but we do plan to add technical positions for our European market testing and
      development in 2007. We anticipate continuing to employ a total of nine
      consultants serving in most of the same capacities in 2007.





**ITEM
      3. CONTROLS AND PROCEDURES.**





EVALUATION
      OF DISCLOSURE CONTROLS AND PROCEDURES. O2Diesel's Chief Executive Officer and
      Chief Financial Officer have evaluated the effectiveness of O2Diesel's
      disclosure controls and procedures (as such term is defined in Rules13a-15
      and
      15d-15 under the Securities Exchange Act of 1934, as amended) as of the end
      of
      the period covered by this quarterly report (the “Evaluation Date”). Based on
      such evaluation, such officers have concluded that, as of the Evaluation Date,
      O2Diesel's disclosure controls and procedures are effective.


10




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007





CHANGES
      IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. During the most recent fiscal
      quarter, there have not been any changes in the Company's internal controls
      over
      financial reporting or in other factors that have materially affected, or are
      reasonably likely to materially affect internal controls over financial
      reporting.





**PART
      II. OTHER INFORMATION**




**ITEM
      1. LEGAL PROCEEDINGS.**





None.




**ITEM
      2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS.**





Between
      June 26, 2007 and July 16, 2007, the Company entered into Agreements with five
      European institutional and private investors for
      the
      sale of 6,123,346 shares of the Company’s common stock at a purchase price of
      approximately $0.41 per share in a private placement, for total proceeds of
      $2,517,710, less commissions. As a condition to the enforceability of these
      agreements against the Company, the investors were required to fund the purchase
      price in an escrow account, which funds were received between June 19, 2007
      and
      July 31, 2007.





As
      part
      of the sale, the Company will issue warrants to purchase 1,530,827 shares of
      common stock at an exercise price of $0.62 per share during the period of six
      months to sixty-six months subsequent to issuance. The warrants expire sixty-six
      months after the date of issuance.





The
      Company is obligated to file a registration statement with the SEC including
      the
      common stock and the shares issuable upon conversion of the warrants within
      90
      days of the closing date. If the registration statement is not filed within
      90
      days, the Company will pay the investors penalties equal to 1.0% of their
      investment amount for the first 30 days and 1.5% of their investment amount
      for
      every 30 days thereafter with a maximum penalty of 8% of the value of the common
      stock as defined in the Agreements. The penalty may be paid in cash or stock
      at
      the option of the Company. The Company will use its reasonable best efforts
      to
      cause such registration statements to become effective within 90 days, or 120
      days if such registration statement is subject to review by the staff of the
      SEC, in each case from the initial filing thereof. All the costs and expense
      incurred in connection with the registration of the common stock and warrants
      will be paid by the Company. The
      Company held the initial closing for this transaction on July 20, 2007.




**ITEM
      3. DEFAULTS UPON SENIOR SECURITIES.**





Not
      applicable.




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





None





**ITEM
      5. OTHER INFORMATION.**





None




11




O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2007


**ITEM
      6. EXHIBITS.**





The
      following exhibits are filed herewith.




ExhibitNumber
            
            Description10.1
            
            Form
                of  Common Stock and Warrant Purchase Agreement for
                $2.52 million Private Placement (1)10.2
            
            Form
                of Warrant for $2.52 million Private Placement (1)31.1
            
            Certification
                of the Chief Executive Officer pursuant to Rule 13a-14(a) or
                Rule 15d-14(a), as adopted pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002(2)31.2
            
            Certification
                of the Chief Financial Officer pursuant to Rule 13a-14(a) or
                Rule 15d-14(a), as adopted pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002(2)32.1
            
            Certification
                of the Chief Executive Officer and Chief Financial Officer pursuant
                to 18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002(2)




(1)
            Previously
                filed as an exhibit to the Company's current report on Form 8-K/A
                on July
                20, 2007, and incorporated herein by reference.(2)
            Filed
                herewith




**12. SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, as amended, the
      registrant has duly caused this report to be signed on its behalf by the
      undersigned hereunto duly authorized.


O2DIESEL
                CORPORATION
              (Registrant)Date:
                August 14, 2007
            By:
            /s/
                Alan RaeAlan
                RaeChief
                Executive Officer
              (Principal
                Executive Officer)





Date:
                August 14, 2007
            By:
            /s/
                David H. ShipmanDavid
                H. ShipmanChief
                Financial Officer
              (Principal
                Financial and Accounting
                Officer)




12