** **

**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON,DC 20549**

 

**FORM 10-Q**

 

| x | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|---|------------|---------------------------------------------------------------------------------------------------------|

 

**FOR THEQUARTERLY PERIOD ENDED March 31, 2008**

 

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

 

**For thetransition period from to                    to                    **

**CommissionFile Number: 001-32228**

 

**O2DIESELCORPORATION**

(Name of smallbusiness issuer in its charter)

 

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

 

100 COMMERCEDRIVE, Suite 301

NEWARK, DELAWARE19713

(Address ofPrincipal Executive Offices)

 

(302) 266-6000

(Issuer’stelephone number)

 

Not Applicable

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

 

Check whether theIssuer (1) filed all reports required to be filed by Section 13 or 15(d) ofthe

SecuritiesExchange Act during the past 12 months (or for such shorter period thatthe registrant was

required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes x  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer”,“accelerated filer” and “small reporting company” in Rule 12b-2 of theExchange Act (Check one):

 

Large acceleratedfiler  o   Accelerated filer  o    Non-accelerated filer o    Smaller Reporting company x

 

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

Yes o  No x

 

 

State the numberof shares outstanding of each of the issuer’s classes of common

equity, as of thelatest practicable date:

 

As of May 10,2008, the registrant had 87,418,674 shares of Common Stock,

$0.0001 par valueper share, issued and outstanding

 

 

 

O2DIESELCORPORATION

FOR THE QUARTERENDED MARCH 31, 2008

INDEX TO FORM 10-Q

 
| PART I FINANCIAL  INFORMATION                                              |   |
|---------------------------------------------------------------------------------|--------|
|                                                                            |   |
|                                                                            |   |
| Item 1. Financial  Statements                                              | F-1    |
|                                                                            |   |
|                                                                            |   |
| Item 2. Management’s Discussion and Analysis or  Results of Operation | 1      |
|                                                                            |   |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk             | 11     |
|                                                                            |   |
|                                                                            |   |
| Item 4. Controls and Procedures                                            | 12     |
|                                                                            |   |
|                                                                            |   |
| PART II  OTHER INFORMATION                                                 |   |
|                                                                            |   |
|                                                                            |   |
| Item 1.  Legal Proceedings                                                 | 12     |
|                                                                            |   |
| Item  1A Risk Factors                                                           | 12     |
|                                                                            |   |
|                                                                            |   |
| Item 2. Unregistered Sales of Equity Securities  and Use of Proceeds       | 12     |
|                                                                            |   |
|                                                                            |   |
| Item 3. Defaults Upon Senior Securities                                    | 12     |
|                                                                            |   |
|                                                                            |   |
| Item 4. Submission of Matters to a Vote of  Security Holders               | 12     |
|                                                                            |   |
|                                                                            |   |
| Item 5.  Other Information                                                 | 12     |
|                                                                            |   |
|                                                                            |   |
| Item 6. Exhibits                                                           | 13     |
|                                                                            |   |
|                                                                            |   |
| Signatures                                                                      | 13     |

 

NOTE REGARDINGFORWARD LOOKING STATEMENTS

 

This quarterly report on Form 10-Qcontains forward-looking statements concerning O2Diesel Corporation (“O2Diesel,”the “Company” or the “Registrant”) and its future operations, plans and othermatters. Any statements that involve discussions with respect to predictions,expectations, beliefs, plans, projections, objectives, assumptions or futureevents 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 notstatements of historical fact and may be “forward looking statements” whichinclude statements relating to, among other things, the ability of O2Diesel tosuccessfully compete in the fuel additive and fuel distribution business.

 

O2Diesel cautions readersnot to place undue reliance on any such forward-looking statements, which speakonly as of the date made. Such forward-looking statements are based on thebeliefs of O2Diesel’s management as well as on assumptions made by andinformation currently available to O2Diesel at the time such statements weremade. Forward-looking statements are subject to a variety of risks anduncertainties which could cause actual events or results to differ from thosereflected in the forward-looking statements, including, without limitation, thefailure to obtain adequate financing on a timely basis and other risks anduncertainties. Actual results could differ materially from those projected inthe forward-looking statements, as a result of either the matters set forth orincorporated in this report generally or certain economic and business factors,some of which may be beyond the control of O2Diesel. These factors includeadverse economic conditions, entry of new and stronger competitors, inadequatecapital, unexpected costs, failure to gain product approval in the UnitedStates or foreign countries for the commercialization and distribution of ourproducts, failure to capitalize upon access to new markets and failure inobtaining the quality and quantity of ethanol necessary to produce our productat competitive prices. O2Diesel disclaims any obligation subsequently to reviseany forward-looking statements to reflect events or circumstances after thedate of such statements or to reflect the occurrence of anticipated orunanticipated events.

 

 

** **

**02DieselCorporation**

**(ADevelopment Stage Company)**

**ConsolidatedBalance Sheets**

**March 31,2008 and December 31, 2007**

**(Unaudited)**

 
| ** **                                                          | ** ** | **March 31, 2008** | ** **    | **December 31, 2007** | ** **    |
|---------------------------------------------------------------------|------------|------------------------------|---------------|---------------------------------|---------------|
| **ASSETS**                                                          | ** ** | ** **                   | ** **    | ** **                      | ** **    |
| **CURRENT  ASSETS**                                                 |       |                         |          |                            |          |
| Cash                                                                |       | $                            | 267,803       |                            |          | $ | 581,645 |   |   |
| Restricted cash                                                     |       | 1,251,044                    |          |                            | 2,333,959     |   |   |
|                                                                |       |                         |          |                            |          |   |   |
| Accounts  receivable                                                |       | 99,861                       |          |                            | 115,536       |   |   |
| Other  receivables                                                  |       | 172,440                      |          |                            | 192,619       |   |   |
| Unbilled  appropriations                                            |       | 162,971                      |          |                            | 145,576       |   |   |
| Inventory                                                           |       | 172,183                      |          |                            | 174,447       |   |   |
| Prepaid  expenses, parts and deposits                               |       | 224,510                      |          |                            | 209,428       |   |   |
|                                                                |       |                         |          |                            |          |   |   |
| Total current  assets                                               |       | 2,350,812                    |          |                            | 3,753,210     |   |   |
|                                                                |       |                         |          |                            |          |   |   |
| **FURNITURE  AND EQUIPMENT**                                        |       |                         |          |                            |          |   |   |
| Office furniture  and equipment                                     |       | 270,930                      |          |                            | 268,828       |   |   |
| Fuel and test  equipment                                            |       | 369,136                      |          |                            | 382,971       |   |   |
|                                                                |       | 640,066                      |          |                            | 651,799       |   |   |
| Less accumulated  depreciation                                      |       | (279,823                     | )             |                            | (283,742      | ) |   |
|                                                                |       | 360,243                      |          |                            | 368,057       |   |   |
|                                                                |       |                         |          |                            |          |   |   |
| **TOTAL  ASSETS**                                                   | ** ** | **$**                        | **2,711,055** | ** **                      | ** **    | **$** | **4,121,267** | ** ** | ** ** |
|                                                                |       |                         |          |                            |          |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**            |       |                         |          |                            |          |   |   |
| **CURRENT  LIABILITIES**                                            |       |                         |          |                            |          |   |   |
| Accounts payable                                                    |       | $                            | 1,966,751     |                            |          | $ | 1,774,248 |   |   |
| Accrued expenses                                                    |       | 352,513                      |          |                            | 568,442       |   |   |
| Deferred grants                                                     |       | 417,116                      |          |                            | 475,980       |   |   |
| Deferred  marketing program                                         |       | 67,833                       |          |                            | 86,333        |   |   |
| Total current  liabilities                                          |       | 2,804,213                    |          |                            | 2,905,003     |   |   |
|                                                                |       |                         |          |                            |          |   |   |
| **TOTAL  LIABILITIES**                                              | ** ** | **2,804,213**                | ** **    | ** **                      | **2,905,003** | ** ** | ** ** |
|                                                                |       |                         |          |                            |          |   |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT)**                            | ** ** | ** **                   | ** **    | ** **                      | ** **    | ** ** | ** ** |
| Preferred stock:  par value of $0.0001; 20,000,000 shares           |       |                         |          |                            |          |   |   |
| authorized; none  issued and outstanding                            |       | -                            |          |                            | -             |   |   |
| Common stock:  par value of $0.0001; 135,000,000 shares authorized; |       |                         |          |                            |          |   |   |
| 86,883,556 and  86,666,837 shares issued and outstanding            |       |                         |          |                            |          |   |   |
| at  March 31, 2008 and December 31, 2007, respectively    |       | 8,688                        |          |                            | 8,667         |   |   |
| Additional  paid-in capital                                         |       | 45,273,073                   |          |                            | 45,123,009    |   |   |
| Unearned  compensation                                              |       | (8,800                       | )             |                            | (14,668       | ) |   |
| Accumulated  other comprehensive loss                               |       | 37,469                       |          |                            | 12,088        |   |   |
| Deficit  accumulated during the development stage                   |       | (45,403,588                  | )             |                            | (43,912,832   | ) |   |
| Total  stockholders’ equity (deficit)                          |       | (93,158                      | )             |                            | 1,216,264     |   |   |
|                                                                |       |                         |          |                            |          |   |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**      | ** ** | **$**                        | **2,711,055** | ** **                      | ** **    | **$** | **4,121,267** | ** ** | ** ** |

 

*See Notes to Consolidated Financial Statements*

 

F-2

 

**O2DIESEL CORPORATION**

**(A Development Stage Company)**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 

**For the three months ended March 31, 2008 and 2007and the**

**Period from October 14, 2000 (inception) through March 31,2008**

**(Unaudited)**

** **
| ** **                                            | ** **                         | ** **                                           | ** **                         | ** **              | ** **                         | **October 14, 2000** | ** ** |
|-------------------------------------------------------|------------------------------------|------------------------------------------------------|------------------------------------|-------------------------|------------------------------------|--------------------------------|------------|
| ** **                                            | ** **                         | ** **                                           | ** **                         | ** **              | ** **                         | **(inception)**                | ** ** |
| ** **                                            | ** **                         | **Three Months Ended March 31,** | ** **                         | **through**             | ** **                         |
| ** **                                            | **     ** | **2008**                                             | **     ** | **2007**                | **     ** | **March 31, 2008**   | ** ** |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Revenue:**                                          |                               |                                                 |                               |                    |                               |                           |       |
| Additive related  sales                               |                               | $                                                    | 13,285                             |                    | $                                  | 165,963                        |       | $ | 788,697 |   |
| Sponsorship  income                                   |                               | -                                     |                               | 15,750                  |                               | 169,248                        |       |
|                                                  |                               | 13,285                                               |                               | 181,713                 |                               | 957,945                        |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Expenses:**                                         |                               |                                                 |                               |                    |                               |                           |       |
| Cost of goods  sold                                   |                               | 8,226                                                |                               | 131,381                 |                               | 583,785                        |       |
| ProEco operating  expenses                            |                               | 15,000                                               |                               | -        |                               | 415,673                        |       |
| Selling and  marketing                                |                               | 250,493                                              |                               | 326,209                 |                               | 9,516,458                      |       |
| Product testing  and government grants, net           |                               | 33,958                                               |                               | 163,115                 |                               | 1,633,571                      |       |
| General and  administrative                           |                               | 1,313,485                                            |                               | 2,033,275               |                               | 34,400,915                     |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Total operating expense**                           |                               | 1,621,162                                            |                               | 2,653,980               |                               | 46,550,402                     |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Operating  loss**                                   | ** **                         | **(1,607,877)**                                      | ** **                         | **(2,472,267)**         | ** **                         | **(45,592,457)**               | ** ** |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Other  income (expense):**                          |                               |                                                 |                               |                    |                               |                           |       |
| Interest expense                                      |                               | (2,230)                                              |                               | (1,853)                 |                               | (135,095)                      |       |
| Interest income                                       |                               | 1,232                                                |                               | 22,390                  |                               | 235,830                        |       |
| Foreign currency  gain/(loss), net                    |                               | 120,977                                              |                               | 47,306                  |                               | 926,421                        |       |
| Loss on  impairment of contruction in progress        |                               | -                                     |                               | -        |                               | (1,288,614)                    |       |
| Other  (expense)/income, net                          |                               | (2,858)                                              |                               | (110)                   |                               | 304,685                        |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Total other income (expense)**                      |                               | 117,121                                              |                               | 67,733                  |                               | 43,227                         |       |
| ** **                                            |                               |                                                 |                               |                    |                               |                           |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Loss  before provision (benefit) for income taxes** |                               | (1,490,756)                                          |                               | (2,404,534)             |                               | (45,549,230)                   |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| Benefit for  income taxes                             |                               | -                                     |                               | -        |                               | 145,642                        |       |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Net  loss**                                         | ** **                         | **(1,490,756)**                                      | ** **                         | **(2,404,534)**         | ** **                         | **(45,403,588)**               | ** ** |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Deemed  dividend to preferred stockholders**        | ** **                         | **-   **                              | ** **                         | **-   ** | ** **                         | **(6,200,005)**                | ** ** |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| **Net  loss allocable to common stockholders**        | ** **                         | **$**                                                | **(1,490,756)**                    | ** **              | **$**                              | **(2,404,534)**                | ** ** | **$** | **(51,603,593 )** | ** ** |
|                                                  |                               |                                                 |                               |                    |                               |                           |       |
| Net loss per  common share                            |                               |                                                 |                               |                    |                               |                           |       |
| (basic and  diluted)                                  |                               | $                                                    | (0.02)                             |                    | $                                  | (0.03)                         |       | $ | (1.30 ) |   |
| Weighted average  shares of common                    |                               |                                                 |                               |                    |                               |                           |       |
| shares  outstanding                                   |                               | 86,699,431                                           |                               | 75,314,434              |                               | 66,654,235                     |       |
| Recapitalization  resulting from the AAE              |                               |                                                 |                               |                    |                               |                           |       |
| Technologies  International PLC acquisition           |                               | -                                     |                               | -        |                               | (17,657,707)                   |       |
| Weighted average  shares of common                    |                               |                                                 |                               |                    |                               |                           |       |
| shares  outstanding - giving effect to the            |                               |                                                 |                               |                    |                               |                           |       |
| recapitalization                                      |                               | 86,699,431                                           |                               | 75,314,434              |                               | 48,996,528                     |       |

 

*See Notes to Consolidated Financial Statements*

 

F-3

 

**O2DIESEL CORPORATION**

** (A DevelopmentStage Company)**

** CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

 

**October 14, 2000 (inception) through March 31,2008**

**(Unaudited)**

** **
| ** **                                                                                          | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                    | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|-------------|------------|------------|------------|-------------------------------|------------|
| ** **                                                                                          | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**  | ** ** | **Amount** | ** ** | **Unearned  Compensa-  tion** | ** ** | **Common  Stock   Subscribed** | ** ** | **Additional  Paid-In  Capital** | ** ** |
| ** **                                                                                          | ** ** | ** **               | ** ** | ** **            | ** ** | ** **  |       |       |       |                          |       |   |   |   |   |
| Balance at October 14, 2000  (Inception)                                                       |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Common stock issued in exchang  for interest in wholly owned  subsidiaries                          |       | —                   |       | $                     | —     |        | 43,008,772 |       | $          | 430,088                       |       | $ | — |   | $ | — |   | $ | 3,603,415 |   |
| Net loss                                                                                            |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Foreign currency translation  adjustment                                                            |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
| Comprehensive loss                                                                                  |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
| Common stock issued on various  dates during 2001                                                   |       | —                   |       | —                |       | 24,181,038  |       | 241,810    |       | —                        |       | — |   | 1,268,031 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Balance at December 31, 2001                                                                   |       | —                   |       | —                |       | 67,189,810  |       | 671,898    |       | —                        |       | — |   | 4,871,446 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Net loss                                                                                            |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
| Foreign currency translation adjustment                                                             |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
| Comprehensive loss                                                                                  |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Common stock issued at $0.225 per  share on various dates during 2002                               |       | —                   |       | —                |       | 703,282     |       | 7,033      |       | —                        |       | — |   | 515,657 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Balance at December 31, 2002                                                                   |       | —                   |       | —                |       | 67,893,092  |       | 678,931    |       | —                        |       | — |   | 5,387,103 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Net loss                                                                                            |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
| Foreign currency translation   adjustment                                                           |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
| Comprehensive loss                                                                                  |       | —                   |       | —                |       | —      |       | —     |       | —                        |       | — |   | — |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Common stock issued on various  dates during 2003                                                   |       | —                   |       | —                |       | 555,556     |       | 5,556      |       | —                        |       | — |   | 119,444 |   |
| Common stock issued for consulting  services                                                        |       | —                   |       | —                |       | 200,000     |       | 2,000      |       | —                        |       | — |   | 43,000 |   |
| Common stock issued for remaining  interest in subsidiaries on July 15,  2003                  |       | —                   |       | —                |       | 4,356,200   |       | 43,562     |       | —                        |       | — |   | 46,323 |   |
| Common stock issued upon exercise  of stock options on various dates  during 2003                   |       | —                   |       | —                |       | 8,670,881   |       | 86,709     |       | —                        |       | — |   | 1,131,595 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Recapitalization resulting from AAE  acquisition on July 15, 2003                              |       | —                   |       | —                |       | (56,928,690 | )          | (814,283   | )          | —                        |       | — |   | 814,283 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Common stock issued at $1.50 per  share on various dates during 2003                                |       | —                   |       | —                |       | 3,333,333   |       | 333        |       | —                        |       | — |   | 4,999,667 |   |
|                                                                                                |       |                     |       |                  |       |        |       |       |       |                          |       |   |   |   |   |
| Expenses 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 |   | 11,745,765 |   |
|                                                                                                     |            |                          |            |                       |            |             |            |            |            |                               |            |  |  |  |  |  |  |  |  |  |

 

*See Notes to Consolidated Financial Statements*

 

F-4

 

**O2DIESELCORPORATION****(A Development Stage Company)CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

 

**October 14,2000 (inception) through March 31, 2008 (Continued)**

**(Unaudited)**

** **
| ** **                                                       | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | ** **    | ** ** | ** ** | ** ** | ** **   | ** ** |
|------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|---------------|------------|------------|------------|--------------|------------|
| ** **                                                       | ** ** | ** **               | ** ** | ** **            | ** ** | ** **    | ** ** | ** ** | ** ** | **Unearned** | ** ** | **Common** | ** ** | **Additional** | ** ** |
| ** **                                                       | ** ** | ** **               | ** ** | ** **            | ** ** | **Compensa-** | ** ** | **Stock**  | ** ** | **Paid-In**  | ** ** |
| ** **                                                       | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**    | ** ** | **Amount** | ** ** | **tion**     | ** ** | **Subscribed** | ** ** | **Capital** | ** ** |
|                                                             |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
|                                                             |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Net 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 | ) | 1,535,770 |   |
|                                                             |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Preferred stock issued on various dates  during 2004             |       | 1,550,000                |       | 155                   |       | —        |       | —     |       | —       |       | — |   | 5,478,609 |   |
|                                                             |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Balance at December 31, 2004                                |       | 1,550,000                |       | 155                   |       | 29,150,823    |       | 2,915      |       | —       |       | — |   | 18,760,144 |   |

 
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
|--------------------------------------------------------------------|--------|-----------|--------|--------|--------|------------|--------|--------|--------|--------|--------|--------|--------|------------|--------|
| Net loss                                                           |   | —    |   | — |   | —     |   | — |   | — |   | — |   | —     |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Foreign currency translation adjustment                            |   | —    |   | — |   | —     |   | — |   | — |   | — |   | —     |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Comprehensive loss                                                 |   | —    |   | — |   | —     |   | — |   | — |   | — |   | —     |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Common stock issued for consulting  services                       |   | —    |   | — |   | 63,750     |   | 6      |   | — |   | — |   | 63,094     |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Warrants issued for consulting services in  2005                   |   | —    |   | — |   | —     |   | — |   | — |   | — |   | 135,000    |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Common stock issued at $0.70 per share on  various dates in 2005   |   | —    |   | — |   | 7,515,981  |   | 752    |   | — |   | — |   | 4,832,439  |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Common stock issued at $0.7125 per share  on various dates in 2005 |   | —    |   | — |   | 3,228,070  |   | 322    |   | — |   | — |   | 2,090,178  |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Common stock issued at $0.564 per share  on various dates in 2005  |   | —    |   | — |   | 6,419,840  |   | 642    |   | — |   | — |   | 3,599,658  |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
|                                                               |   |      |   |   |   |       |   |   |   |   |   |   |   |       |   |
| Balance at December 31, 2005                                  |   | 1,550,000 |   | 155    |   | 46,378,464 |   | 4,637  |   | — |   | — |   | 29,480,513 |   |

 
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
|---------------------------------------------------------------------------|--------|------------|--------|--------|--------|------------|--------|--------|--------|----------|--------|--------|--------|------------|--------|
| Net loss                                                                  |   | —     |   | — |   | —     |   | — |   | —   |   | — |   | —     |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Foreign currency translation adjustment                                   |   | —     |   | — |   | —     |   | — |   | —   |   | — |   | —     |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Comprehensive loss                                                        |   | —     |   | — |   | —     |   | — |   | —   |   | — |   | —     |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Common stock issued via exercise of  warrants on various dates in 2006    |   | —     |   | — |   | 3,151,892  |   | 315    |   | —   |   | — |   | 1,457,829  |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Common stock issued for consulting  services in 2006                      |   | —     |   | — |   | 56,250     |   | 6      |   | —   |   | — |   | 50,994     |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Conversion 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    |   | —   |   | — |   | 6,256,282  |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Common stock issued at $0.729 per share  in 2006                          |   | —     |   | — |   | 1,371,742  |   | 138    |   | —   |   | — |   | 979,367    |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Fair value of unvested stock options upon  adoption of SFAS 123(R)   |   | —     |   | — |   | —     |   | — |   | (376,031 | )      | — |   | 376,031    |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Amortization of unearned compensation                                     |   | —     |   | — |   | —     |   | — |   | 250,890  |   | — |   | —     |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Fair value of stock options issued in 2006                                |   | —     |   | — |   | —     |   | — |   | —   |   | — |   | 1,476,684  |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
|                                                                      |   |       |   |   |   |       |   |   |   |     |   |   |   |       |   |
| Balance at December 31, 2006                                         |   | —     |   | — |   | 75,125,014 |   | 7,513  |   | (125,141 | )      | — |   | 40,076,305 |   |

 

*SeeNotes to Consolidated Financial Statements*

 

F-5

 

**O2DIESELCORPORATION(A Development Stage Company)CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

 

**October 14, 2000 (inception) through March 31,2008 (Continued)**

**(Unaudited)**

** **
| ** **                                                  | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | ** **    | ** ** | ** ** | ** ** | ** **   | ** ** |
|-------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|---------------|------------|------------|------------|--------------|------------|
| ** **                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | ** **    | ** ** | ** ** | ** ** | **Unearned** | ** ** | **Common** | ** ** | **Additional** | ** ** |
| ** **                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | **Compensa-** | ** ** | **Stock**  | ** ** | **Paid-In**  | ** ** |
| ** **                                                  | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**    | ** ** | **Amount** | ** ** | **tion**     | ** ** | **Subscribed** | ** ** | **Capital** | ** ** |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Net loss                                                    |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Foreign currency translation  adjustment                    |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Comprehensive loss                                          |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Common stock issued to employee                             |       | —                   |       | —                |       | 333,333       |       | 33         |       | —       |       | — |   | 273,266 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Fair value of unearned shares related to   ommitment shares |       | —                   |       | —                |       | 805,987       |       | 80         |       | —       |       | — |   | 668,889 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Unearned common stock issued for  commitment shares         |       | —                   |       | —                |       | (465,170      | )          | (47        | )          | —       |       | — |   | (386,044 | ) |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Fusion shares issued at various prices  in 2007             |       | —                   |       | —                |       | 970,994       |       | 97         |       | —       |       | — |   | 499,903 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Common stock issued for consulting  services                |       | —                   |       | —                |       | 540,000       |       | 54         |       | —       |       | — |   | 263,446 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Common stock issued at $0.405 per  share in 2007            |       | —                   |       | —                |       | 2,993,346     |       | 299        |       | —       |       | — |   | 1,109,944 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Repurchase of shares                                        |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Retirement of repurchased shares                            |       | —                   |       | —                |       | (100,000      | )          | (10        | )          | —       |       | — |   | (40,090 | ) |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Common stock issued at $0.417 per  share in 2007            |       | —                   |       | —                |       | 3,130,000     |       | 313        |       | —       |       | — |   | 1,194,821 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Common stock issued at $0.375 per  share in 2007            |       | —                   |       | —                |       | 3,333,333     |       | 334        |       | —       |       | — |   | 1,249,666 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Amortization of unearned  compensation                      |       | —                   |       | —                |       | —        |       | —     |       | 110,473      |       | — |   | (24,727 | ) |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Fair value of stock options issued in  2006 and 2007        |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | 237,631 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Balance at December 31, 2007                           |       | —                   |       | —                |       | 86,666,837    |       | 8,667      |       | (14,668      | )          | — |   | 45,123,009 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Net loss                                                    |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
| Foreign currency translation  adjustment                    |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Comprehensive loss                                          |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | — |   |
| Unearned common stock issued for  commitment shares         |       | —                   |       | —                |       | 96,719        |       | 9          |       | —       |       | — |   | 80,247 |   |
| Common stock issued for consulting  services                |       | —                   |       | —                |       | 120,000       |       | 12         |       | —       |       | — |   | 36,226 |   |
| Amortization of unearned  compensation                      |       | —                   |       | —                |       | —        |       | —     |       | 5,868        |       | — |   | — |   |
| Fair value of stock options issued in  2006 and 2007        |       | —                   |       | —                |       | —        |       | —     |       | —       |       | — |   | 33,591 |   |
|                                                        |       |                     |       |                  |       |          |       |       |       |         |       |   |   |   |   |
| Balance at March 31, 2008                              |       | —                   |       | $                     | —     |          | 86,883,556 |       | $          | 8,688        |       | $ | (8,800 | ) | $ | — |   | $ | 45,273,073 |   |
|                                                             |            |                          |            |                       |            |               |            |            |            |              |            |  |  |  |  |  |  |  |  |  |

 

*SeeNotes to Consolidated Financial Statements*

 

F-6

 

**O2DIESELCORPORATION(A Development Stage Company)CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

 

**October 14,2000 (inception) through March 31, 2008 (Continued)**

**(Unaudited****)**

** **
| ** **                                                                                         | ** ** | **Common  Stock  Subscriptions  Receivable** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Deficit  Accumulated  During the  Development  Stage** | ** ** | **Total  Stockholders’  Equity  (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                                                   |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 1,509,841                                        |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance 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                             |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 522,690                                          |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance 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                                                   |       | —              |       | —                                                        |       | 179,689                                          |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Comprehensive loss                                                                                 |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | (4,050,607                                       | )          |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock issued on various dates during 2003                                                   |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 125,000                                          |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock issued for consulting services                                                        |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 45,000                                           |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common 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                              |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 5,000,000                                        |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Expenses 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                                     | )          | —                                                    |       | —              |       | —                                                        |       | 952,350                                          |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance at December 31, 2003                                                                  |       | (180,000                                     | )          | 101,128                                                   |       | —              |       | (11,898,106                                                   | )          | 903,945                                          |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Net 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                                      |       | —                                                    |       | —              |       | —                                                        |       | 583,527                                          |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Preferred stock issued on various dates during 2004                                                |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 5,478,764                                        |       |
|                                                                                               |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance at December 31, 2004                                                                  |       | —                                       |       | 3,682                                                     |       | —              |       | (18,626,120                                                   | )          | 140,776                                          |       |

 

*SeeNotes to Consolidated Financial Statements*

 

F-7

 

**O2DIESELCORPORATION**

**(ADevelopment Stage Company)**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

 

**October 14,2000 (inception) through March 31, 2008 (Continued)**

**(Unaudited)**

** **
| ** **                                                                | ** ** | **Common  Stock  Subscriptions  Receivable** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Deficit  Accumulated  During the  Development  Stage** | ** ** | **Total  Stockholders’  Equity  (Deficit)** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------|------------|
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Net loss                                                                  |       | —                                       |       | —                                                    |       | —              |       | (6,852,165                                                    | )          | (6,852,165                                       | )          |
| Foreign currency  translation adjustment                                  |       | —                                       |       | 2,329                                                     |       | —              |       | —                                                        |       | 2,329                                            |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Comprehensive  loss                                                       |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | (6,849,836                                       | )          |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock  issued for consulting services in 2005                      |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 63,100                                           |       |
| Warrants issued  for consulting services in 2005                          |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 135,000                                          |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock  issued at $0.70 per share on various dates in 2005          |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 4,833,191                                        |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock  issued at $0.7125 per share on various dates in 2005        |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 2,090,500                                        |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock  issued at $0.564 per share on various dates in 2005         |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 3,600,300                                        |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance at  December 31, 2005                                        |       | —                                       |       | 6,011                                                     |       | —              |       | (25,478,285                                                   | )          | 4,013,031                                        |       |
| Net 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    |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 1,458,144                                        |       |
| Common stock  issued for consulting services in 2006                      |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 51,000                                           |       |
| Conversion of  preferred stock into common stock on various dates in 2006 |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | —                                           |       |
| Common stock  issued at $0.75 per share in 2006                           |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 6,257,149                                        |       |
| Common stock  issued at $0.729 per share in 2006                          |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 979,505                                          |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Fair value of  unvested stock options upon adoption of SFAS 123(R)   |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | —                                           |       |
| Amortization of  unearned compensation                                    |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 250,890                                          |       |
| Fair value of  stock options issued in 2006                               |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 1,476,684                                        |       |
|                                                                      |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance at  December 31, 2006                                        |       | —                                       |       | (4,381                                                    | )          | —              |       | (33,086,440                                                   | )          | 6,867,856                                        |       |

 

*SeeNotes to Consolidated Financial Statements*

 

F-8

 

**O2DIESELCORPORATION**

**(ADevelopment Stage Company)**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

 

**October 14,2000 (inception) through March 31, 2008 (Continued)**

**(Unaudited)**

** **
| ** **                                                  | ** ** | **Common  Stock  Subscriptions  Receivable** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Deficit  Accumulated  During the  Development  Stage** | ** ** | **Total  Stockholders’  Equity  (Deficit)** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------|------------|
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Net loss                                                    |       | —                                       |       | —                                                    |       | —              |       | (10,826,392                                                   | )          | (10,826,392                                      | )          |
| Foreign currency  translation adjustment                    |       | —                                       |       | 16,469                                                    |       | —              |       | —                                                        |       | 16,469                                           |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Comprehensive  loss                                         |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | (10,809,923                                      | )          |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock  issued to employee                            |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 273,299                                          |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Fair value of  unearned shares related to commitment shares |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 668,969                                          |       |
| Unearned common  stock issued for commitment shares         |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | (386,091                                         | )          |
| Fusion shares  issued at various prices in 2007             |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 500,000                                          |       |
| Common stock  issued for consulting services                |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 263,500                                          |       |
| Common stock  issued at $0.405 per share in 2007            |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 1,110,243                                        |       |
| Repurchase of  shares                                       |       | —                                       |       | —                                                    |       | (40,100             | )          | —                                                        |       | (40,100                                          | )          |
| Retirement of  repurchased shares                           |       | —                                       |       | —                                                    |       | 40,100              |       | —                                                        |       | —                                           |       |
| Common stock  issued at $0.417 per share in 2007            |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 1,195,134                                        |       |
| Common stock  issued at $0.375 per share in 2007            |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 1,250,000                                        |       |
| Amortization of  unearned compensation                      |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 85,746                                           |       |
| Fair value of  stock options issued in 2006 and 2007        |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 237,631                                          |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance at  December 31, 2007                          |       | —                                       |       | 12,088                                                    |       | —              |       | (43,912,832                                                   | )          | 1,216,264                                        |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Net loss                                                    |       | —                                       |       | —                                                    |       | —              |       | (1,490,756                                                    | )          | (1,490,756                                       | )          |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Foreign currency  translation adjustment                    |       | —                                       |       | 25,381                                                    |       | —              |       | —                                                        |       | 25,381                                           |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Comprehensive  loss                                         |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | (1,465,,375                                      | )          |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Unearned common  stock issued for commitment shares         |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 80,256                                           |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Common stock  issued for consulting services                |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 36,238                                           |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Amortization of  unearned compensation                      |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 5,868                                            |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Fair value of  stock options issued in 2006 and 2007        |       | —                                       |       | —                                                    |       | —              |       | —                                                        |       | 33,591                                           |       |
|                                                        |       |                                         |       |                                                      |       |                |       |                                                          |       |                                             |       |
| Balance at  March 31, 2008                             |       | $                                            | —     |                                                      | $          | 37,469              |       | $                                                             | —     |                                             | $          | (45,403,588 | ) | $ | (93,158 | ) |
|                                                             |            |                                              |            |                                                           |            |                     |            |                                                               |            |                                                  |            |  |  |  |  |  |

 

*SeeNotes to Consolidated Financial Statements*

 

F-9

 

**O2DIESELCORPORATION**

**(ADevelopment Stage Company)**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 

**Forthe three months ended March 31, 2008 and 2007 and the**

**Periodfrom October 14, 2000 (inception) through March 31, 2008**

**(Unaudited)**

 
| ** **                                                               | ** ** | ** **                                           | ** **     | ** ** | ** **                   | ** ** | ** **     | **October 14, 2000** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|----------------|------------|------------------------------|------------|----------------|--------------------------------|------------|
| ** **                                                               | ** ** | **Three Months Ended March 31,** | ** **     | ** ** | **(inception) through** | ** ** |
| ** **                                                               | ** ** | **2008**                                             | ** **     | ** ** | **2007**                     | ** ** | ** **     | **March 31, 2008**   | ** ** |
| **Cash  flows from operating activites**                                 |       |                                                 |           |       |                         |       |           |                           |       |
| **Net  loss**                                                            | ** ** | **$**                                                | **(1,490,756** | **)**      | ** **                   | **$**      | **(2,404,534** | **)**                          | ** ** | **$** | **(45,403,588** | **)** |
| Adjustments to  reconcile loss to net cash used in operating activities: |       |                                                 |           |       |                         |       |           |                           |       |
| Depreciation                                                             |       | 20,918                                               |           |       | 21,595                       |       |           | 402,294                        |       |
| Amortization                                                             |       | —                                               |           |       | —                       |       |           | 7,786                          |       |
| Write off of  patent                                                     |       | —                                               |           |       | —                       |       |           | 337,329                        |       |
| Write off of  obsolete inventory                                         |       | —                                               |           |       | —                       |       |           | 5,925                          |       |
| Loss (gain) on  sale/disposal of furniture & equipment          |       | (3,807                                               | )              |       | —                       |       |           | 6,445                          |       |
| Loss on  impairment of construction in progress                          |       | —                                               |           |       | 1,288,614                    |       |           |                           |       |
| Non cash  contributions                                                  |       | —                                               |           |       | —                       |       |           | 5,312                          |       |
| Common stock and  warrants issued for consulting services                |       | 36,238                                               |           |       | —                       |       |           | 553,838                        |       |
| Common stock  issued to employee                                         |       | —                                               |           |       | 136,667                      |       |           | 273,299                        |       |
| Common stock  issued for commitment shares                               |       | 80,256                                               |           |       | 42,054                       |       |           | 363,134                        |       |
| Amortization of  unearned compensation                                   |       | 39,459                                               |           |       | 127,042                      |       |           | 2,090,410                      |       |
| Changes in  operating assets and liabilites:                             |       |                                                 |           |       |                         |       |           |                           |       |
| Accounts  receivable                                                     |       | 15,675                                               |           |       | (129,842                     | )          |           | (99,861                        | )          |
| Other  receivables                                                       |       | 20,179                                               |           |       | 145,612                      |       |           | (172,440                       | )          |
| Inventory,  prepaid expenses and other current assets                    |       | (30,213                                              | )              |       | (103,489                     | )          |           | (565,589                       | )          |
| Accounts payable                                                         |       | 192,503                                              |           |       | 284,811                      |       |           | 1,966,751                      |       |
| Accrued expenses                                                         |       | (215,929                                             | )              |       | (98,843                      | )          |           | 341,355                        |       |
| Deferred grants                                                          |       | (58,864                                              | )              |       | 102,991                      |       |           | 417,116                        |       |
| Deferred  marketing program                                              |       | (18,500                                              | )              |       | (73,224                      | )          |           | 67,833                         |       |
| **Cash  flows used in operating activities**                             | ** ** | **(1,412,841**                                       | **)**          | ** ** | **(1,949,160**               | **)**      | ** **     | **(38,114,037**                | **)**      |
|                                                                     |       |                                                 |           |       |                         |       |           |                           |       |
| **Cash  flows from investing activities**                                |       |                                                 |           |       |                         |       |           |                           |       |
| Restricted cash                                                          |       | 1,082,915                                            |           |       | 417,461                      |       |           | (1,251,044                     | )          |
| Purchase of  furniture and equipment                                     |       | (16,297                                              | )              |       | (4,012                       | )          |           | (2,070,998                     | )          |
| Proceeds from  sale of furniture & equipment                    |       | 7,000                                                |           |       | —                       |       |           | 20,150                         |       |
| Purchase of  patent                                                      |       | —                                               |           |       | —                       |       |           | (345,115                       | )          |
| **Cash  flows provided by (used in) investing activities**               | ** ** | **1,073,618**                                        | ** **     | ** ** | **413,449**                  | ** ** | ** **     | **(3,647,007**                 | **)**      |
|                                                                     |       |                                                 |           |       |                         |       |           |                           |       |
| **Cash  flows from financing activities**                                |       |                                                 |           |       |                         |       |           |                           |       |
| Net proceeds  from issuance of preferred stock                           |       | —                                               |           |       | —                       |       |           | 5,478,764                      |       |
| Net proceeds  from private placement                                     |       | —                                               |           |       | —                       |       |           | 5,953,757                      |       |
| Purchase of  treasury stock                                              |       | —                                               |           |       | —                       |       |           | (40,100                        | )          |
| Net proceeds  from issuance of common stock                              |       | —                                               |           |       | —                       |       |           | 30,605,870                     |       |
| **Cash  flows provided by financing activities**                         | ** ** | **—**                                           | ** **     | ** ** | **—**                   | ** ** | ** **     | **41,998,291**                 | ** ** |
| ** **                                                               | ** ** | ** **                                           | ** **     | ** ** | ** **                   | ** ** | ** **     | ** **                     | ** ** |
| Effect of exchange  rate changes on cash                                 |       | 25,381                                               |           |       | 2,702                        |       |           | 30,556                         |       |
|                                                                     |       |                                                 |           |       |                         |       |           |                           |       |
| **Net  (decrease)/increase in cash**                                     | ** ** | **(313,842**                                         | **)**          | ** ** | **(1,533,009**               | **)**      | ** **     | **267,803**                    | ** ** |
| ** **                                                               | ** ** | ** **                                           | ** **     | ** ** | ** **                   | ** ** | ** **     | ** **                     | ** ** |
| **Cash at  beginning of period**                                         | ** ** | **581,645**                                          | ** **     | ** ** | **3,065,630**                | ** ** | ** **     | **—**                     | ** ** |
| ** **                                                               | ** ** | ** **                                           | ** **     | ** ** | ** **                   | ** ** | ** **     | ** **                     | ** ** |
| **Cash at  end of period**                                               | ** ** | **$**                                                | **267,803**    | ** ** | ** **                   | **$**      | **1,532,621**  | ** **                     | ** ** | **$** | **267,803** | ** ** |
|                                                                     |       |                                                 |           |       |                         |       |           |                           |       |
| Cash paid for  interest                                                  |       | $                                                    | 2,230          |       |                         | $          | 1,853          |                           |       | $ | 123,513 |   |
|                                                                     |       |                                                 |           |       |                         |       |           |                           |       |
| Cash paid for  income taxes                                              |       | None                                                 |           |       | None                         |       |           | None                           |       |

 

Non-cashtransactions: 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.

 

*SeeNotes to Consolidated Financial Statements*

 

F-10

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

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

 

***The Company***

 

O2Diesel Corporation (“O2Diesel”or the “Company”) is in the development stage and has developed a proprietaryadditive product designed to enable distillate liquid transportation fuels toburn cleaner by facilitating the addition of ethanol as an oxygenate to thesefuels. To date, the Company’s operations have continued to be focused onraising capital, performing research and development, and bringing its productto market.

 

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 Corporationeffective June 10, 2003, in contemplation of the reverse acquisition ofAAE Technologies International Plc (“AAE”). On July 15, 2003, O2DieselCorporation acquired all of the issued and outstanding shares of AAE inexchange for 17,847,039 shares of its common stock. As a result of thistransaction, the former shareholders of AAE acquired control of the combinedcompanies. The acquisition of AAE has been accounted for as a capitaltransaction followed by a recapitalization. AAE was considered to be theaccounting acquirer. Accordingly, the historical financial statements of AAEare considered to be those of O2Diesel Corporation for all periods presented.

 

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

 

On June 15, 2004,the American Stock Exchange (“AMEX” or “Exchange”) approved an application tolist 46,518,898 shares of our common stock under the symbol OTD. Subsequent tothis date, the Exchange has approved additional applications to list 74,173,483shares of the Company’s common stock so that the total number of sharesapproved for listing is now 120,692,381. Our shares began to trade on theExchange on July 1, 2004.

 

O2Diesel wasreincorporated in the state of Delaware in a transaction that became effectiveon December 31, 2004.

 

**Basis ofPresentation**

 

The Company’s unauditedconsolidated financial statements for the three months ended March 31, 2008have been prepared on a going concern basis, which contemplates the realizationof assets and the settlement of liabilities and commitments in the normalcourse of business.  We have reclassifiedcertain prior-period amounts to conform to the current period’spresentation.  If the Company were tocontinue to incur losses without additional funding and were to fail tocontinue as a going concern, then its assets and liabilities would be requiredto be stated on a liquidation basis which would differ significantly from thegoing concern basis.

 

At March 31, 2008,the Company had negative working capital of $453,401, of which $1,251,044 wasrestricted in use to operational costs associated with developing markets inEurope, and had accumulated losses of $45,403,588.  At December 31, 2007, the Company hadpositive working capital of $848,207, of which $2,333,959 was restricted in useto operational costs associated with developing markets in Europe, and hadaccumulated losses of $43,912,832.  Thelack of adequate working capital and continuing losses create an uncertaintyabout the Company’s ability to continue as a going concern. The financialstatements do not include any adjustments that might be necessary if theCompany is unable to continue as a going concern.

 

Management has concludedthat additional equity must be raised in 2008 in order for the Company to havesufficient cash to execute its business plan.

 

**AMEX Delisting**

 

On June 29, 2007,the Company was notified by AMEX that it was not in compliance with the listingstandards of the Exchange because it lacked the requisite amount ofstockholders’ 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 intocompliance 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 totake to return to full compliance. The Company has entered into a common stockpurchase agreement with Fusion Capital Fund II, LLC to raise up to$10 million in new

 

F-11

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

equity over a twenty-fivemonth period starting on February 16, 2007. Also, the Company announced aprivate placement in which we raised an additional $2.52 million in July andAugust 2007. As noted below, the Company planned to raise additional newequity in conjunction with the acquisition of the ProEco Energy Company (“ProEco”).We believed these actions were needed to enable us to meet or exceed the equityrequirements of the Exchange.

 

On September 13,2007, the Company received a written notice from the AMEX indicating that AMEXhad reviewed and accepted the Company’s plan to regain listing qualificationscompliance.  With the acceptance of theplan, the Company was able to continue its listing during the plan periodpursuant to an extension granted until December 29, 2008.  The AMEX notice also advised the Companythat, in addition to the previously disclosed deficiency with respect to Section 1006(a)(iii) ofthe AMEX Company Guide, it had triggered an additional deficiency with respectto Section 1003(a)(ii) of the AMEX Company Guide which requireslisted companies to have at least $4.0 million of stockholders’ equity when ithas sustained losses from continuing operations and/or net losses in its fourmost recent fiscal years.

 

Under the terms of thenotice from AMEX, the Company was to continue to provide AMEX staff withupdates regarding initiatives set forth in its plan of compliance.  The Company has been subject to periodicreview by AMEX staff during the interim period. If the Company was not in compliance on December 29, 2008, or theCompany did not make progress consistent with the plan during the interimperiod, the AMEX would likely initiate procedures to de-list the Company’scommon stock. If the Company’s common stock were to be de-listed by the AMEX,the Company’s shares would continue to be traded as a bulletin board stock.

 

On January 8, 2008,the Company announced that due to the unfavorable market conditions for raisingcapital for ethanol plants, the Company and ProEco agreed to defer furtherdiscussions regarding the development of the Ethanol Plant until conditions inthe capital markets improved.

 

On February 7, 2008,the Company received notice from the staff of the AMEX that, due to thedeferral of the ProEco project, the Company was no longer demonstratingprogress consistent with the July 27, 2007 plan and had determined toproceed with an application to the Securities and Exchange Commission to removethe common stock of the Company from listing and registration on AMEX. Thisaction, which was appealed by the Company, was taken because the Company wasnot in compliance with Section 1003(a)(iii) of the AMEX Company Guide,in that its stockholders’ equity was less than $6 million and it hadsustained losses from continuing operations and/or net losses in its five mostrecent fiscal years. In addition, the Company was not in compliance with Section 1003(a)(ii) asits stockholders’ equity was less than $4 million and it had sustainedlosses from continuing operations and/or net losses in three out of four of itsmost recent fiscal years.

 

On February 12,2008, the Company appealed the delisting determination by requesting an oralhearing to present its plan, its progress in achieving the plan and maintainingits AMEX listing. On April 4, 2008, the Company received notice from AMEXthat it was not in compliance with Section 1003(a)(i), in that the Company’sstockholders’ equity was less than $2 million and it had sustained losses fromcontinuing operations and/or net losses in two of its three most recent fiscalyears, and Section 1003(a)(iv) which concerns the delisting of thesecurities of a company based on the amount of such losses and the impairmentof its financial condition.  Subsequentto an oral hearing on April 15, 2008, the Company received notice fromAMEX on April 21, 2008 indicating its determination to prohibit thecontinued listing of the Company’s common stock on the Exchange and to initiatedelisting proceedings.

 

On April 28, 2008the Company announced that it began trading on the Pink Sheet ElectronicQuotation Service under the trading symbol OTOD.PK.

 

The consolidatedfinancial statements in this report do not include any adjustments to reflectthe anticipated private placements or the possible future effects on therecoverability and classification of assets or the amounts and classificationof liabilities that may result should management be unsuccessful in obtainingfinancing on terms acceptable to the Company.

 

Since July 2003, theCompany has raised approximately $37 million for its operations.

 

F-12

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**2.Summary of Significant Accounting Policies**

 

**Principlesof Consolidation**

 

The consolidatedfinancial statements include the accounts of the Company and all affiliatedsubsidiaries. All significant inter-company balances and transactions have beeneliminated in consolidation. Based on Financial Accounting Standards Board (“FASB”) InterpretationNo. 46R, *Consolidation of VariableInterest Entities*” (“FIN 46R”), the Company is the holder of themajority of the risks and rewards relating to ProEco Energy Company, Inc.(“ProEco”). As such, the Company is considered to be the “primary beneficiary”of ProEco, deemed to be a variable interest entity (“VIE”), and has includedProEco’s assets, liabilities and operating results in its consolidatedfinancial statements for the three months ended March 31, 2008 and for theperiod October 14, 2000 (inception) through March 31, 2008.

 

**VariableInterest Entity (VIE)**

 

In general, a VIE is acorporation, partnership, limited-liability corporation, trust or any otherlegal structure used to conduct activities or hold assets that either (i) hasan insufficient amount of equity to carry out its principal activities withoutadditional subordinated financial support; (ii) has a group of equityowners that are unable to make significant decisions about its activities; or (iii) hasa group of equity owners that do not have the obligation to absorb losses orthe right to receive returns generated by its operations. Based on theseguidelines, the Company has determined that ProEco is a VIE beginning with thethird quarter of 2007. Prior to that period, activity with ProEco was notmaterial.

 

**Cash andCash Equivalents**

 

The Company considers allhighly liquid instruments with a maturity of three months or less at the timeof issuance to be cash equivalents. As of March 31, 2008 and December 31,2007, cash deposits exceeded federally insured limits which are generally$100,000 per financial institution.

 

**RestrictedCash**

 

On December 16, 2005, theCompany completed a private placement of its common stock, whereby it receivedapproximately $3.6 million which is restricted to operational costs associatedwith developing markets in Europe.  In2008, the Company notified the investor in this private placement that it hastemporarily utilized a portion of these funds for current non-Europeanoperating purposes.  The investor hasacknowledged this temporary utilization with the expectation that these fundswill be repaid.  The Company has usedapproximately $852,000 of these funds through May 9, 2008.  In addition to the $467,000 temporarilyutilized for non-European operating purposes during the three month periodended March 31, 2008, restricted funds declined by approximately $615,000,net of approximately $120,000 in foreign currency gains, as a result ofmarketing expenditures in Europe.

 

Prior to 2005, restricted cash consisted of cash held in the Company’sbank account pursuant to the provisions set forth in documents to the acquisitionof AAE on July 15, 2003.  The restrictedfunds associated with the acquisition of AAE were released in equal amounts onOctober 15, 2003, and January 15, 2004.  

 

**FairValue of Financial Instruments**

 

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

 

**Concentrationof Credit Risk and Allowance for Doubtful Accounts**

 

The Company provides anallowance for doubtful accounts for estimated losses resulting from theinability of customers to make required payments. The Company does not requirecollateral and it does not charge finance fees on outstanding tradereceivables. The allowance is determined by analyzing historical data andtrends, as well as specific customers’ financial conditions. Past-due ordelinquency status is based upon the credit terms for that specific customerfrom the date of delivery. Charges for doubtful accounts are recorded inselling and marketing expenses. Trade accounts receivables are written offagainst the allowance for doubtful accounts when collection appears unlikely.

 

F-13

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**2.Summary of Significant Accounting Policies (Continued)**

 

**Inventories**

 

Inventories, consistingof fuel additive held at third party locations, are stated at the lower of costas determined using the first in, first out (FIFO) method, or marketvalue.

 

**Furniture,Equipment, Construction in Progress** **and Depreciation**

 

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

 

Office furniture andequipment: 3 to 5 years

Fuel and test equipment:5 to 20 years

 

Depreciation expenserecorded in the accompanying Consolidated Statements of Operations was $20,918,$21,595 and $402,294 for the three months ended March 31, 2008 and 2007and for the period October 14, 2000 (inception) through March 31,2008, respectively.

 

**Accountingfor Impairment of Long-Lived Assets**

 

The carrying values ofintangible and long-lived assets are reviewed on a regular basis for theexistence of facts or circumstances that may suggest impairment. The Companyrecognizes impairment when the sum of the expected undiscounted future cashflows 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 itsestimated fair value.

 

In light of thepostponement of the Ethanol Plant project, due to unfavorable marketconditions, the Company has re-examined the carrying value of the constructionin progress asset. As of December 31, 2007, management had evaluated thisproject based on its assessment of the challenges to financing projects of thisnature, posed by the present debt and equity markets, as well as the limitedlikelihood that a buyer will be identified for this project in the near future.Accordingly, the Company believed that it was prudent not to assign a value tothis asset. As such, an impairment charge of $1,288,614 was warranted and thisadjustment was recorded in December 2007.

 

**RevenueRecognition**

 

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

 

The Company has developedthe CityHomeTM program to serve as an important element of itssales/marketing and product demonstration strategy. This program involves thesale of our additive, the receipt of sponsorship fees and the potential sale ofadvertising space. As with other customers, revenue from the sales of productis recognized and recorded upon the passage of title of the product to thecustomer and following confirmation that the customer is utilizing the finalblended fuel. Sponsorship fees will become additional revenue for us and willbe recognized as such over the period of the contract when a sponsorshipagreement is signed and the fees have been invoiced. Costs that are intended tobe supported by the sponsorship fees are recorded separately in the relatedexpense line in our statement of operations. With regard to the advertisingspace, since the CityHomeTM program is still in its beginning phase and since wehave been unable to assess the fair market value of the advertising spacereceived, we assign no value to the space at the time of receipt. We arerecognizing the value associated with the advertising space when we enter intoa contract arrangement with a third party. The Company will consider assigninga fair value to the advertising space received at the time of the initial salewhen such fair value is more readily determinable, based upon a history of cashtransactions.

 

The Company has supportedcertain fleet equipment conversion costs in these CityHomeTM initiatives and hasalso been required to bear the incremental costs of the blended fuel, where itis experienced. Whenever the expected costs of the program are determined to bein excess of the contracted sponsorship fees and related fuel additive revenue,the Company records the loss for the contract as an expense and a deferredliability to be amortized over the life of the contract. As of March 31,2008 and December 31, 2007, costs remaining to be amortized for CityHomeTMprograms were recorded on the balance sheet as Deferred Marketing Program inthe amount of $67,833 and $86,333, respectively. The Company recorded $1,147,$17,059 and $1,223,150 in costs for the CityHomeTM initiatives, in excess of sponsorshipfees, during the three months ended March 31, 2008 and 2007 and for theperiod October 14, 2000 (inception) through March 31, 2008,respectively.

 

F-14

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**2.Summary of Significant Accounting Policies (Continued)**

 

**Shippingand Handling Costs**

 

The Company classifiescosts associated with shipping and handling activities within cost of goodssold in the consolidated statements of operations.

 

**AdvertisingExpenses**

 

Advertising costs areexpensed as incurred. Advertising expense was $0, $0 and $450,000 for the threemonths ended March 31, 2008 and 2007 and for the period October 14,2000 (inception) to March 31, 2008, respectively.

 

**Researchand Development Costs**

 

Research and developmentcosts are expensed as incurred.

 

**ProductTest and Demonstration Appropriations**

 

The Company receivesappropriations from governmental agencies to fund certain of its research anddevelopment efforts. The Company evaluates the conditions of each appropriationand either increases revenue, decreases expenses or reduces the cost of fixedassets depending upon the attributes of the underlying grant. Appropriationsactivities are not recognized until there is reasonable assurance that theCompany will comply with the conditions of the grant and that the grant will bereceived.

 

**Net LossPer Common Share (Basic and Diluted)**

 

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

 

**Accountingfor Stock-Based Compensation**

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), *“Share-Based Payment”* (“SFAS 123(R)”), which replacesFASB Statement No. 123, *“Accounting forStock-Based Compensation”* (“SFAS 123”) and supersedesAccounting Principles Board (“APB”) Opinion No. 25 (“APB 25”). Priorto January 1, 2006, the Company’s share-based employee compensation planwas accounted for under the recognition and measurement provisions ofAPB 25 and related Interpretations, as permitted by SFAS 123. TheCompany did not recognize stock-based compensation cost in its statement ofoperations for periods prior to December 31, 2005 as all options grantedhad an exercise price equal to or higher than the market value of theunderlying common stock on the date of grant. However, compensation expense wasrecognized under APB 25 for certain options granted to non-employees ofthe Company based upon the intrinsic value. SFAS 123(R) requires allshare-based payments, including grants of employee stock options, to berecognized in the financial statements based on their fair values beginningwith the first interim period after December 15, 2005, with early adoptionencouraged. The pro forma disclosures previously permitted under SFAS 123will no longer be an alternative to financial statement recognition.

 

Effective January 1,2006, the Company adopted the fair value recognition provisions ofSFAS 123(R) using the modified prospective transition method. As aresult, the Company’s net loss before taxes was $1,727,574 higher for theperiod October 14, 2000 (inception) through March 31, 2008, than ifit had continued to account for share-based compensation under APB 25.

 

Stock options generallyvest over three years and expire ten years from the effective date. However,the Company has the latitude under the Incentive Plan to issue options atvarious stages of vesting. Once these options are granted by the Board ofDirectors under the provisions of the plan, the Company will record acompensation charge for the difference between the fair value of the commonstock and the exercise price of the options on the date of issuance if the fairvalue of the common stock exceeds the exercise price of the option on thatdate.  During the three months ended March 31,2008 and 2007, no additional options were granted and, in the first quarter of2008, 200,000 options expired unexercised.

 

F-15

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**2.Summary of Significant Accounting Policies (Continued)**

 

The fair value ofeach option granted was estimated on the date of grant using the Black-Scholesoption-pricing model. The assumptions used with this model were as follows:

 
| ** **                | ** ** | **2007 ** | ** ** | **2006 ** | ** ** | **2005 ** | ** ** |
|---------------------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| Expected life             |       | 3 years   |       | 3 years   |       | 3 years   |       |
| Dividend yield            |       | 0              | %          | 0              | %          | 0              | %          |
| Volatility  range*        |       | 73             | %          | 72–209    | %          | 59–120    | %          |
| Risk-free  interest rate* |       | 4.16           | %          | 4.64–5.09 | %          | 3.39–3.96 | %          |

 

----

* Depending on thedate of grant.

 

**IncomeTaxes**

 

Income taxes areaccounted for using the liability method in accordance with SFAS No. 109,*Accounting for Income Taxes*. Under SFAS109, deferred tax assets or liabilities are computed based upon the differencebetween the financial statement and income tax bases of assets and liabilitiesusing the enacted marginal tax rate applicable when the related asset orliability is expected to be realized or settled. Deferred income tax expense orbenefits are based on the changes in the asset or liability from period toperiod. If available evidence suggests that it is more likely than not thatsome portion or all of a deferred tax asset will not be realized, a valuationallowance is recorded to reduce the deferred tax assets to the amount that ismore likely than not to be realized. Future changes in such valuation allowancewould be included in the provision for deferred income taxes in the period ofchange.

 

In June, 2006, the FASBissued Interpretation No. 48, *“Accountingfor Uncertainty in Income Taxes”*(FIN 48) which was effectivefor fiscal years beginning after December 15, 2006. This interpretationclarified the accounting for uncertainty in income taxes recognized inaccordance with SFAS 109. Specifically, FIN 48 clarifies theapplication of SFAS 109 by defining a criterion that an individual taxposition must meet for any part of the benefit of that position to berecognized in an enterprise’s financial statements. Additionally, FIN 48provides guidance on measurement, derecognition, classification, interest andpenalties, accounting in interim periods of income taxes, as well as therequired disclosure and transition. This interpretation was effective forfiscal years beginning after December 15, 2006. Effective January 1,2007, the Company adopted FIN 48 and has determined that such adoption hasnot had a significant effect on the Company’s consolidated financial positionand results of operations.

 

**Use ofEstimates**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the reportingperiods. Actual results could differ from those estimates.

 

**ForeignSubsidiaries**

 

The Company has foreignsubsidiaries whose local currency has been determined to be the functionalcurrency. For these foreign subsidiaries, the assets and liabilities have beentranslated using the period-end exchange rates, and the income and expenseshave been translated using the weighted average of historical exchange ratesduring the reporting period. The adjustments resulting from translation havebeen recorded separately in shareholders’ equity (deficit) as “othercomprehensive income (loss)” and are not included in determining theconsolidated net loss. As of March 31, 2008 and December 31, 2007,accumulated other comprehensive income included $37,469 and $12,088, respectively,of cumulative income from foreign currency translation.

 

The Company beganoperations in Brazil in March of 2004 by establishing a 75% ownedsubsidiary. The Brazilian subsidiary recognized revenue of $0, $0 and $7,682for the three months ended March 31, 2008 and 2007 and for the period October 14,2000 (inception) through March 31, 2008, respectively. Brazil also hadtotal assets less current liabilities (exclusive of intercompany amountseliminated in consolidation) of $98,147 and $95,201 at March 31, 2008 and December 31,2007, respectively. Transactions in Brazil are denominated in, and thefunctional currency is, the Brazilian Real. Accordingly, no Brazilianoperations currency exchange rate gains or losses are recorded in theaccompanying consolidated statement of operations. At March 31, 2008 and December 31,2007, the Brazilian operation had aggregate losses of $2,175,320 and$2,038,986, respectively. The minority stockholder’s portion of aggregatelosses is not recorded in the consolidated balance sheet since reimbursement ofthis amount from the minority stockholders is not assured.

 

F-16

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**2.Summary of Significant Accounting Policies (Continued)**

 

On December 31,2004, the Company ceased operations at two of its wholly-owned subsidiaries inthe United Kingdom. In connection with the cessation, the Company recorded anexchange gain in the 2004 consolidated statement of operations of $94,396 torecognize cumulative translation gains previously recorded in othercomprehensive income (loss). The subsidiaries were primarily holding companiesand had no assets or liabilities as of December 31, 2004. Since that date,these subsidiaries incurred no activity and therefore had no profit or loss.

 

The company beganoperations in Spain in April of 2006 by establishing a 100% subsidiary.The Spanish subsidiary recognized $0, $0 and $12,176 of revenue for thethree months ended March 31, 2008 and 2007 and for the period of April 2006through March 31, 2008, respectively. At March 31, 2008 and December 31,2007, the Spanish subsidiary had total assets less current liabilities(exclusive of intercompany amounts eliminated in consolidation) of $419,505 and$275,678, respectively. Transactions in Spain are denominated in, and thefunctional currency is, the Euro. At March 31, 2008 and December 31,2007, the Spanish operation had aggregate losses of $2,334,738 and $1,933,878.

 

The Company expanded itsoperations in Ireland in August 2007 by establishing a 100% ownedsubsidiary. At March 31, 2008, this subsidiary had not been an activecompany.

 

**SegmentReporting**

 

The Company is adevelopment stage company and has not made sales of its products in commercialvolumes. Management believes that the Company currently operates and managesthe business as one business segment.

 

**Impairmentof Intellectual Property Rights**

 

Prior to the fourthquarter of 2002, the Company was pursuing the marketability of a technology ithad acquired for $424,659. In December, 2002, the Company determined that therelated product was no longer commercially viable and would no longer bepursued. As a result of this decision, it was determined that the asset wouldnot be recoverable as there was no alternative market for the technology.Accordingly, the net book value of $345,115 was charged to general andadministrative expenses during 2002.

 

**InterimFinancial Statements**

 

The unaudited interimconsolidated financial statements of the Company have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information. In the opinion of management, alladjustments (consisting of normal recurring adjustments) considered necessaryto present fairly the financial position of the Company as of March 31,2008 and December 31, 2007 and the results of operations and cash flowspresented herein for the three month periods ended March 31, 2008 and2007and from inception (October 14, 2000) through March 31, 2008 havebeen included in the financial statements. Interim results are not necessarilyindicative of results of operations that may be expected for the year ending December 31,2008. It is recommended that this financial information be read with thecomplete financial statements included in the Company’s Form 10-KSB dated December 31,2007 previously filed with the SEC on March 31, 2008.

 

**3.ProEco Transaction**

 

On January 12, 2007,the Company entered into a Share Exchange Agreement (the “Agreement”) withProEco Energy Company (“ProEco”) and its shareholders (“ProEco Shareholders”)to acquire shares equal to 80% of the outstanding capital stock of ProEco inexchange for approximately 9.2 million shares of the Company’s commonstock (the “Transaction Shares”) valued at $0.872 per share for a totalpurchase price of $8.0 million.

 

ProEco, which has hadlimited operations to date, had been in the process of developing a newfuel-grade Ethanol Plant with planned capacity of at least 100 milliongallons per year to be built in two 50 million gallon stages (each a “Train”).Pursuant to the terms of the Agreement, ProEco Shareholders would receive 60%of the Transaction Shares at the time of the closing and would receive theremaining 40% of the Transaction Shares in two equal installments upon thecompletion of construction of the first Train (20%) and the commencement ofconstruction of the final Train (20%). The remaining 40% of the TransactionShares would be held in escrow until the conditions for their release had beenmet. The parties intended the transaction to qualify as a tax-freereorganization under Section 368(a) of the U.S. Internal Revenue Codeof 1986, as amended (the “Code”).

 

The Agreement requiredProEco to complete a number of steps toward completion of the Ethanol Plantproject in order for the closing of the share exchange to occur. At the time ofthe closing, ProEco was required to have entered into a definitive engineering,

 

F-17

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**3.ProEco Transaction (continued)**

 

procurement andconstruction (“EPC”) contract, with a reputable firm with extensive experiencein implementing and completing projects similar to the Ethanol Plant project,and executed marketing agreements for the sale of the production of the EthanolPlant as well as corn feedstock. Pursuant to the terms of the Agreement, ProEcowas responsible for having the Ethanol Plant designated as a facilitynameplated, or certified, as producing ethanol at a level of at least100 million gallons of production a year.

 

As a condition to theclosing of the ProEco share exchange, the Company was obligated to secure thefinancing necessary to complete the construction costs to build the EthanolPlant. Accordingly, the Company was required to raise $60 to $70 millionin debt and between $30 and $40 million in equity in the first quarter of2008 for each train.

 

Prior to closing, theCompany and the ProEco Shareholders were to enter into a stockholder agreementthat will, among other things, impose restrictions on the transfer of theTransaction Shares.

 

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

 

Pursuant to the terms ofthe letter of intent for the Agreement, the Company agreed to enter into asecured loan agreement with ProEco for the purposes of financing the purchaseoptions for the land to be used for the Ethanol Plant and certain engineeringand permitting work required for the closing of the ProEco share exchange. Theannual interest rate on the loan is 7% and the maturity date of the loan was December 15,2007.

 

Current trends in theethanol industry have seen increases in the price of corn and other feedstocksas well as a decline in the average selling price of ethanol. For a number ofnew plant construction projects, the lack of EPC contractor availability hasresulted in increased costs and delays in completion dates. On January 8,2008, the Company announced that due to the unfavorable market conditions forraising capital for ethanol plants, the Company and ProEco had entered into anagreement to extend the Share Exchange Agreement and the maturity date of theloan from the Company to ProEco until January 31, 2008. These agreementswere subsequently extended again until February 29, 2008. On March 19,2008, the Company and ProEco entered into a letter agreement terminating theShare Exchange Agreement and extending the maturity date of the loan from February 29,2008 until November 30, 2008. The Company and ProEco have agreed tocontinue to develop the Ethanol Plant when conditions in the capital marketsimprove. At December 31, 2007, management had evaluated this project basedon its assessment of the challenges to financing projects of this nature, posedby the existing debt and equity markets, as well as the limited likelihood thata buyer would be identified for this project in the near future. Accordingly,the Company believed that it was prudent not to assign a value to this asset.As such, an impairment charge of $1,288,614 was warranted and this adjustmentwas recorded in December 2007.

 

Based on FIN 46R,the Company is the holder of the majority of the risks and rewards relating toProEco. As such, the Company is considered to be the “primary beneficiary” ofProEco which is deemed to be a VIE. (In general, a VIE is a corporation,partnership, limited-liability corporation, trust or any other legal structureused to conduct activities or hold assets that either (i) has aninsufficient amount of equity to carry out its principal activities withoutadditional subordinated financial support; (ii) has a group of equityowners that are unable to make significant decisions about its activities; or (iii) hasa group of equity owners that do not have the obligation to absorb losses orthe right to receive returns generated by its operations.) Based on theseguidelines, the Company has determined that ProEco was a VIE beginning with thethird quarter of 2007 and has included ProEco’s assets, liabilities andoperating results in its consolidated financial statements. Prior to thatperiod, activity with ProEco was not material.

 

The following tablesummarizes the significant assets and liabilities of ProEco as of March 31,2008 and December 31, 2007:

 
| Cash             |   | $       | 8,310 |
|------------------|--------|---------|-------|
| Accounts payable |   | 351,005 |
| Accrued expenses |   | 31,304  |

 

ProEco expenses,including a $1,288,614 impairment charge and after elimination of intercompanytransactions, of $15,000, $0 and $1,704,287 for the three months ended March 31,2008 and a 2007 and the period October 14, 2000 (inception) through March 31,2008, respectively, are also reflected in the Company’s consolidated statementsof operations.

 

F-18

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**4.Common Stock and Warrant Activity During 2008**

 

**Energenics Transactions**

 

On October 17, 2007,the Company entered into a private financing agreement and a joint venturetransaction with Energenics Holdings Pte Ltd (“Energenics Holdings”) toprovide funding and commercial support to develop the Asian market for O2DieselTM , the Company’s ethanol diesel fuel blend.

 

The parties entered intoa Common Stock and Warrant Purchase Agreement (the “Energenics Agreement”), asamended on December 10, 2007 (the “Amendment”), pursuant to whichEnergenics Holdings agreed to purchase 3,333,333 shares of the Company’s commonstock in a private placement, for total proceeds of approximately$1.25 million. The effective per share price of $0.375 represents 121% ofthe market price on the AMEX on the day prior to the signing of the Amendment.As part of the transaction, the Company agreed to issue a warrant to purchase1,666,667 shares of common stock at an exercise price of $0.375 per share,which warrant will be issued upon the closing of the transactions contemplatedby the Energenics Agreement and shall be exercisable from the date that is sixmonths following the date of issuance until October 17, 2012 (“InvestmentWarrant”).

 

The parties also enteredinto a Shareholders Agreement in which Energenics Holdings and the Company willjointly develop the market for O2Diesel TM  in Asia through O2Diesel Asia Limited (“O2DieselAsia”). Energenics agreed to pay the Company $750,000 for a fifty percent (50%)equity interest in O2Diesel Asia. The balance of the interest in O2Diesel Asiawill be held by O2Diesel Europe Limited, a wholly-owned subsidiary of the Company.For the past year, pursuant to the Supply and Distribution Agreement, dated September 15,2006, O2Diesel has supplied its additive to Energenics for the blending anddistribution of O2Diesel TM in the Asian Pacific and South Asia.

 

The parties entered intoa License agreement whereby O2Diesel Europe Limited (formerly AAE TechnologiesInternational Plc) will license to O2Diesel Asia certain patents andknow-how that are required to make and sell O2Diesel TM  in the territory in exchange for certain paymentspursuant to the Shareholders Agreement. In addition, the Company entered into asimilar License agreement with O2Diesel Asia, pursuant to which the Companywill pay to O2Diesel Asia a royalty based on sales of the Company’s product inthe territory.

 

As part of thetransaction, upon the purchase of certain quantities of O2D05 or theequivalent, the Company will also issue a warrant to purchase 1,500,000 sharesof common stock at an exercise price of $0.375 per share, which warrant shallbe exercisable during the period from the date of issuance until October 17,2012 (“JV Warrant”).

 

Also, as part of thetransaction, upon the achievement by Energenics Holdings of certain levels ofadditional purchases of O2D05 or the equivalent, the Company will issue additionalwarrants to purchase up to an aggregate of 6,500,000 shares of common stock ata

price per share equal tothe lesser of $0.375 or 121% of the closing price per share (rounded to thenearest cent) of the Company’s common stock on a public stock exchange on thedate such warrants are earned (“Market Development Warrants,” and, collectivelywith the Investment Warrant and the JV Warrant, the “Warrants”). The MarketDevelopment Warrants are exercisable from the date of issuance to October 17,2012.

 

Due to market conditionsin the global credit markets, Energenics Holdings has funded only a portion ofthis transaction.  The Company hasreceived $1,250,000 in two deposits on November 14, 2007 and December 21,2007.  The Company and Energenics arecurrently renegotiating the terms of this transaction and the final payment of$750,000.  The Company anticipatesclosing this transaction during the second quarter of 2008.

 

**KL Process Transaction**

 

On March 11, 2008,the Company’s wholly owned subsidiary, O2Diesel Europe, Plc (“O2Diesel Europe”)entered into an exclusive Technology License and Services Agreement (the “KLAgreement”) with KL Process Design Group, LLC (“KL”) whereby O2Diesel Europeobtained an exclusive license to use, exploit and sublicense certain KLintellectual property, know-how and processes for the production and sale ofethanol from feedstocks other than simple sugars and starches (the “KL Product”).  KL granted this license to O2Diesel Europe onan exclusive basis in Europe, India, Russia and other rapidly developing globalmarkets.  Pursuant to the Agreement, KLalso agreed to provide certain services related to the design and constructionof production plants necessary to produce the Product.

 

F-19

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**4.Common Stock and Warrant Activity During 2008 (Continued)**

 

As part of the KLAgreement, the Company agreed to issue 1,000,000 shares of the Company’s commonstock to KL as consideration for the license, as well as certain royalty anddesign services fees.  The common stockwill be issued to the accredited investor in a transaction that will be exemptfrom registration pursuant to Section 4(2) of the Securities Actand/or Regulation D promulgated under the Securities Act.

 

**5.Government Appropriations**

 

**Appropriationfrom the U.S. Department of Energy (1)**

 

In 2002, the Companyreceived 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. Theappropriation was increased to $2,039,651 as of September 15, 2004. Thisappropriation is managed for the DOE by the National Renewable Energy Laboratory(“NREL”) under a contract which, as amended, continued until June 30,2007. As of March 31, 2008, NREL has not yet closed this contract. Underthe terms of the contract, the Company is reimbursed by NREL for 80% of thecosts incurred to complete the Statement of Work as set forth in the contract.The Company charges all expenses as incurred to operations and accrues allamounts receivable under the contract as a reduction to contract expenses whenthe Company is reasonably certain all conditions of the reimbursement aresatisfied. As of March 31, 2008 and December 31, 2007, the Companyhad incurred the full cumulative costs of $2,039,651 towards completion of thecontract therefore leaving no balance of costs left to spend in order tocomplete the contract. From the inception of the contract in December 2002through March 31, 2008 and December 31, 2007, the Company billed NREL$1,631,720 of which $16,317 is included in other receivables as of March 31,2008 and December 31, 2007.

 

**Appropriationfrom the U.S. Department of Energy (2)**

 

In 2003, the Companyreceived an appropriation of $1,123,834 to test the Company’s fuel additiveunder the California Air Resources Board (CARB) Diesel Emissions ControlStrategy (DECS) verification rules. The Company is eligible to receivereimbursements of 80% of costs incurred under a contract up to theappropriation amount. This appropriation is managed for the DOE by NREL, theNational Renewable Energy Laboratory. As of March 31, 2008 and December 31,2007, the Company had incurred cumulative costs of $1,029,350 and $986,222,respectively, towards completion of the contract, leaving a balance of $94,484and $137,612, respectively, in costs to complete the contract. From theinception of the contract through March 31, 2008 and December 31,2007, the Company billed NREL $822,520 and $786,847, respectively, of which$42,533 and $57,690 is included in other receivables as of March 31, 2008and December 31, 2007, respectively.

 

**Appropriationfrom the U.S. Department of Energy (3)**

 

During 2004 and 2005, theCompany received $1,000,000 in available appropriations for the purpose ofcontinued testing and verification of our fuel additive. The Company hassubmitted its proposal for several possible test projects and expects to enterinto a contract, eligible for approximately 80% reimbursement, in the secondquarter of 2008.

 

**Appropriationfrom the U.S. Department of Defense (1)**

 

In 2003, the Companyreceived an appropriation of $1,000,000 from the U.S. Department of Defense (“DoD”)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 ofthis Appropriation, a third party is to be paid $200,000 to administer thisprogram on behalf of the Department of Defense. The remaining $800,000 is to beused to fund purchases of O2DieselTM fuel, certain capital equipment and toreimburse the Company for its labor, overhead and out-of-pocket costs requiredto complete this project. Under this program, the Company is required to meetcertain milestones as a condition to receiving reimbursements for its costs.Thus, upon achieving a milestone, the Company accrues the amount due andsubmits an invoice for reimbursement. All amounts are expensed as incurred, andall amounts receivable for work completed are treated as a reduction to expenseover 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 hadachieved five milestones and, since inception, has billed $360,000 related tothis appropriation, of which $160,000 was billed in January, 2005. By itsterms, this contract expired on December 31, 2004 and will not beextended. 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) fromthe DoD as is permitted under that contract. However, the funds fromAppropriation (1) cannot be applied to Appropriation (2). Through December 31,2005, the Company had received cash in excess of costs incurred of $296,097 andhad recorded Deferred Grants at December 31, 2005 in the ConsolidatedBalance Sheet. All amounts billed had been received as of

 

F-20

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**5.Government Appropriations (continued)**

 

December 31, 2005.No additional reimbursements are expected from this appropriation. During thefourth quarter of 2006 the Company was notified from the subcontractor that thecontract was officially closed and O2Diesel has no further requirements. Basedon this information, the Company applied the previously recorded liability of$296,097 for this contract as an offset to 2006 grant expenses for the yearended December 31, 2006.

 

**Appropriationfrom 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 DoD.Under this contract, the Company’s O2DieselTM fuel is to be testedin a maximum of forty (40) non-tactical vehicles at US Air Force bases inNevada for an 18 month period. Furthermore, the Company is to completecertain engine testing and other work required for the acceptance of O2DieselTMas a viable alternative fuel for use by the Air Force. Work on this contractcommenced on November 1, 2004 and continued 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 InnovativeTechnologies Corporation (ITC), was authorized to incur costs in an amount notto exceed $75,000. This is a time and materials contract that is administeredfor the DoD by a third party contractor. The Company charges all costs asincurred to expense and accrues all amounts receivable under the contract as areduction to contract expenses. The contract amount was amended in May 2006to $1,012,564. As of December 31, 2006, costs totaling $1,011,215 had beenincurred and billed, leaving a remaining contract balance of $1,349. As of December 31,2007, this contract was formally closed.

 

**Appropriationfrom the U.S. Department of Defense (3)**

 

The Company received anappropriation during 2005 of approximately $910,000 from the DoD. ConcurrentTechnologies Corporation (CTC) manages this appropriation on behalf of the DoD.This contract contains a payment schedule based on meeting performancemilestones. Four milestones were achieved during 2006 which resulted in issuing$530,000 of invoices during 2006. The primary objective of this contract is tocreate potential fuels using the Company additive that contains no more than80% petroleum. If this project is successful, an application will be made toDOE for “alternative fuel” status, creating an incentive for federal customersto use the fuel. Part of this research entails conducting demonstrations invarious climates at three Air Force bases, including Nellis Air Force Base(expanded fleet) in Nevada and Minot Air Force Base in North Dakota. As of March 31,2008 and December 31, 2007, $884,867 and $860,576 in expenses have beenincurred, leaving an available contract balance of $25,133 and $49,424,respectively. In addition to the $715,000 in expenses that have been invoicedas of March 31, 2008 and December 31, 2007, based on achieving sevenmilestones through 2007, the Company has recorded Unbilled Appropriations of$161,771 and $145,576 at March 31, 2008 and December 31, 2007,respectively, in the consolidated balance sheets.

 

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

 

In 2005, the Companyreceived an appropriation of approximately $1,100,000 for continued testing andverification of O2DieselTM. The Company entered into a contract for$575,000 in 2007. As of March 31, 2008, lab testing of a new fuelcombining O2DieselTM, biodiesel, and diesel had been conducted andfield testing was nearing completion at Nellis Air Force Base in Las Vegas,Nevada. Another field test is planned during mid-2008 at Barksdale Air ForceBase in Shreveport, Louisiana.

 

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

 

In 2006, the Companyreceived an appropriation of approximately $1,000,000 for continued testing andverification of O2Diesel. Of this amount, $688,710 was added during the thirdquarter of 2007 to the contract described in DoD (4), for a total contractamount of $1,263,710 at March 31, 2008 and December 31, 2007. Thiscontract contains a payment schedule based on meeting performance milestones.Six milestones have been achieved through 2007 which resulted in the issuanceof invoices totaling $644,893 and $620,536 as of March 31, 2008 and December 31,2007, respectively. Aggregate costs of $227,777 and $144,556 were incurredunder this contract resulting in the balance of $417,116 and $475,980 beingrecorded in deferred grants in the consolidated balance sheets at March 31,2008 and December 31, 2007, respectively.

 

**Appropriation from the U.S. Department of Defense(6)**

 

In 2007, the Companyreceived an appropriation of approximately $1,600,000 for continued testing andverification of O2DieselTM. The Company will submit its proposal forseveral possible test projects and expects to enter into a contract, eligiblefor approximately 80% of the appropriation, in the second quarter of 2008.

 

F-21

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**6.Other Receivables**

 

Significantcomponents of the Company’s Other Receivables at March 31, 2008 and December 31,2007 are as follows:

 
|                                                    |   | March 31, |    | December 31, |   |
|---------------------------------------------------------|--------|----------------|---------|-------------------|--------|
|                                                    |   | 2008           |    | 2007              |   |
| NREL Appropriation                                      |   | $              | 58,852  |              | $      | 74,007 |   |
| Receivables  related to product demonstrations in Spain |   | 35,756         |    | 45,407            |   |
| VAT receivable  (Spain)                                 |   | 63,424         |    | 57,594            |   |
| Employee travel  advances, etc.                         |   | 14,408         |    | 15,611            |   |
|                                                    |   | $              | 172,440 |              | $      | 192,619 |   |

 

**7.Accrued Expenses**

 

Significantcomponents of the Company’s Accrued Expenses at March 31, 2008 and December 31,2007 are as follows:

 
|                         |   | March 31, |    | December 31, |   |
|------------------------------|--------|----------------|---------|-------------------|--------|
|                         |   | 2008           |    | 2007              |   |
| Legal and  professional fees |   | $              | 153,790 |              | $      | 234,721 |   |
| Payroll-related  liabilities |   | 42,032         |    | 30,304            |   |
| Severance  payments          |   | 90,752         |    | 190,508           |   |
| Other                        |   | 65,939         |    | 112,909           |   |
|                         |   | $              | 352,513 |              | $      | 568,442 |   |

 

**8.Income Taxes**

 

No provision for Federaland state income taxes has been recorded during the periods presented due tothe Company’s significant operating losses. The income tax benefit reflected inthe accompanying consolidated statement of operations is the current benefitrecognized in Ireland for the periods presented.

 

Deferred income taxesreflect the net tax effects of temporary differences between the carrying amountsof assets and liabilities for financial reporting purposes and the amounts usedfor income tax reporting purposes. Significant components of the Company’sdeferred tax asset as of March 31, 2008 and December 31, 2007 are asfollows:

 
|                              |   | March 31,  2008 |                      | December 31,  2007 |        |
|-----------------------------------|--------|----------------------|---------------------------|-------------------------|-------------|
| Net operating  loss carryforwards |   | $                    | 12,750,600                |                    |        | $ | 11,831,969 |   |   |
| Deferred revenue                  |   | 22,500               |                      |                    | 453,020     |   |   |
| Accrued expenses                  |   | 119,200              |                      |                    | 255,818     |   |   |
| Total deferred  tax assets        |   | 12,892,300           |                      |                    | 12,540,807  |   |   |
| Valuation  allowance              |   | (12,892,300          | )                         |                    | (12,540,807 | ) |   |
| Net deferred tax  assets          |   | $                    | -     |                    |        | $ | -     |   |   |

 

Management has determinedthat a valuation allowance equal to 100% of the existing deferred tax asset isappropriate given the uncertainty regarding the ultimate realization of theseassets. At March 31, 2008, the Company had Federal and state net operatingloss carryforwards of approximately $29.3 million for income tax purposes.If not used, these carryforwards begin to expire in 2021. Federal tax rules imposelimitations on the use of net operating losses following certain changes inownership. If such a change occurs, the limitation would reduce the amount ofthe benefits that would be available to offset future taxable income each year,starting with the year of ownership change. As a result, certain amounts of thenet operating loss carryforwards may expire without being utilized. As of March 31,2008, the Company had an Irish net operating loss carryforward of approximately$761,000 which can be carried forward indefinitely, a cumulative Spanish lossof approximately $2.1 million and a Brazilian net operating loss ofapproximately $1.8 million that may be carried forward indefinitely, butwhich is subject to annual usage limitations.

 

F-22

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**8.Income Taxes (continued)**

 

In July 2006, theFASB 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 intax positions, as defined and prescribes the measurement process and a minimumrecognition threshold, for a tax position taken or expected to be taken in atax return, that is required to be met before being recognized in the financialstatements. Under FIN 48, the Company must recognize the tax benefit from anuncertain tax position only if it is more likely than not that the tax positionwill be sustained on examination by the taxing authorities, based on thetechnical merits of the position. The tax benefits recognized in the financialstatements from such a position are measured based on the largest benefit thathas a greater than 50% likelihood of being realized upon ultimate resolution.

 

The Company is subject tothe provisions of FIN 48 as of January 1, 2007, and has analyzed filingpositions in all of the U.S. federal and state jurisdictions where it isrequired to file income tax returns, its federal and state tax returns inIreland, Spain and Brazil and all open tax years in these jurisdictions. TheCompany has identified its U.S. federal tax return and its state tax returns inDelaware and California as “major” tax jurisdictions as defined. Based on theCompany’s evaluation, we have concluded that there are no significant uncertaintax positions requiring recognition in our financial statements. Our evaluationwas performed for the tax years which remain subject to examination by themajor U.S. tax jurisdictions (tax years ended December 31, 2004 to December 31,2007) and for the tax years which remain open for examination in Ireland (December 31,2007), Spain (December 31, 2007) and Brazil (December 31, 2007).Based on this evaluation, no reserves for uncertain income tax positions havebeen recorded pursuant to FIN 48 during the period ended March 31, 2008 andthe Company does not anticipate that it is reasonably possible that anymaterial increase or decrease in its unrecognized tax benefits will occurwithin twelve months. In addition, the Company did not record a cumulativeeffect adjustment related to the adoption of FIN 48.

 

Upon adoption on January 1,2007 and as of March 31, 2008, the Company had no unrecognized taxbenefits or accruals for the potential payment of interest and penalties. TheCompany’s policy for recording interest and penalties associated with taxaudits is to record such items as a component of income or loss beforeprovision (benefit) for income taxes. Penalties are recorded in other expenses,and interest paid or received is recorded in interest expense or interestincome, related to the settlement of tax audits for certain prior periods. Forthe period ended March 31, 2008, there were no penalties or interestrecorded relating to the settlement of tax audits.

 

Federal tax rules underSection 382 of the Code impose limitations on the use of netoperating losses (“NOL”) following certain changes in ownership. If such achange occurs, the limitation would reduce the amount of the benefits thatwould be available to offset future taxable income each year, starting with theyear of ownership change. In general, an ownership change, as defined by Section 382,results from transactions increasing the ownership of certain shareholders orpublic groups in the stock of a corporation by more than 50 percentage pointsover a three-year period. Since the Company’s formation, the Company has raisedcapital through the issuance of capital stock on several occasions which, combinedwith the purchasing shareholders’ subsequent disposition of those shares, mayhave resulted in a change of control, as defined by Section 382, or couldresult in a change of control in the future upon subsequent disposition. TheCompany has not currently completed a study to assess whether a change ofcontrol has occurred or whether there have been multiple changes of controlsince the Company’s formation due to the significant complexity and costassociated with such study and that there could be additional changes incontrol in the future. If we have experienced a change of control at any timesince the Company’s formation, utilization of our NOL carryforwards would besubject to an annual limitation under Section 382. Any limitation mayresult in the expiration of a portion of the NOL carryforwards beforeutilization. Further, until a study is completed and any limitation is known,no amounts are being presented as an uncertain tax position under FIN 48.

 

**9.Stockholders’ Equity**

 

**Recapitalization**

 

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

 

As a result of thetransaction, the historical financial statements of AAE are deemed to be thoseof the Company for financial reporting purposes. The equity accounts of AAEhave been adjusted for the recapitalization to reflect the equity structure ofO2Diesel, the legal acquirer. Specifically, the historical stockholders’ equityof AAE prior to the transaction has been affected for the equivalent number ofshares of O2Diesel common stock received in the transaction, with an offset topaid-in capital; the accumulated deficit of AAE was carried forward after thetransaction; and the loss per share for all periods prior to the transactionwas restated to reflect the number of equivalent common shares received by AAEin the transaction.

 

F-23

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**9.Stockholders’ Equity (Continued)**

 

**CommonStock and Warrant Activity**

 

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

 

Subsequent to its firstprivate placement in 2003, the Company undertook to raise an additional $3.5million through a follow-on private placement of our common stock (the “Follow-OnPrivate Placement”). In the Follow-On Private Placement, we raised $1,535,570,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 completedin non-U.S. transactions were exempt from registration pursuant to Regulation Spromulgated under the Securities Act. The sales of common stock under theFollow-On Private Placement to accredited U.S. investors were exempt pursuantto Regulation D promulgated under the Securities Act.

 

On July 17, 2007,the Company repurchased 100,000 shares of its common stock for treasury for anaggregate 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 tothe day the Company’s board of directors approved the repurchase.  In December 2007, management decided toretire these shares.

 

 **$10.0 Million Private Placement**

 

On February 16,2007, the Company entered into a common stock purchase agreement (the “PurchaseAgreement”) with Fusion Capital Fund II, LLC, an Illinois limited liabilitycompany (“Fusion Capital”). Pursuant to the Purchase Agreement, at the Company’sdiscretion, the Company may sell up to $10.0 million of the Company’s commonstock to Fusion Capital from time to time over a twenty-five month period. TheCompany has reserved for issuance up to 12,000,000 shares of the Company’scommon stock for sale to Fusion Capital under this agreement. The Companyhas issued to Fusion Capital 805,987 shares of the Company’s common stock as acommitment fee for entering into the Purchase Agreement.

 

Concurrent with enteringinto the Purchase Agreement, the Company entered into a registration rightsagreement with Fusion Capital (the “Registration Rights Agreement”). Under theRegistration Rights Agreement, the Company filed a registration statement withthe SEC covering the shares that have been issued or may be issued to FusionCapital under the Purchase Agreement. Subject to earlier termination at theCompany’s discretion, Fusion Capital’s purchases commenced after June 8,2007 when the Securities and Exchange Commission (“SEC”) declared effective theregistration statement related to the transaction. Generally, the Companyhas the right but not the obligation from time to time to sell an aggregate ofup to 12 million shares of the Company’s common stock to Fusion Capital inamounts between $100,000 and $1 million depending on certain conditions. TheCompany has the right to control the timing and amount of any sales of theCompany’s shares to Fusion Capital. The purchase price of the shares will bedetermined based upon the market price of the shares of common stock withoutany fixed discount. Fusion Capital shall not have the right or the obligationto purchase any shares of the Company’s common stock on any business day thatthe 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 terminatedby the Company at any time at its discretion without any cost to the Company.

 

During the quarters endedMarch 31, 2008 and 2007, the Company did not execute any transactionsunder this agreement.  From the effectivedate of this agreement through March 31, 2008, the Company executed fiveseparate transactions, selling a total of 970,994 shares of common stock at anaverage price of $0.515 per share for total proceeds of $500,000.

 

**$2.52Million Private Placement**

 

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

 

F-24

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**9.Stockholders’ Equity (Continued)**

 

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

 

The Company was obligatedto file a registration statement with the SEC including the common stock andthe shares issuable upon exercise of the warrants within 90 days of the closingdate. A Form S-3 registration statement, including these shares and sharesissuable upon exercise of the warrants, was filed by the Company on October 18,2007 and declared effective by the SEC on October 31, 2007. All the costsand expenses incurred in connection with the registration of the common stockand warrants are paid by the Company. The Company closed this transaction on July 20,2007 and August 20, 2007.

 

**Issuancesof Preferred Stock**

 

In March 2004, theCompany approved the designation of two new series of preferred shares. The newpreferred shares, which consist of one million five hundred and fifty thousand(1,550,000) shares of Preferred Stock, are Series A and B 0% ConvertiblePreferred Stock, par value $.0001 (the “Series A Preferred Stock” and “Series BPreferred Stock”). Subsequent to approving the new Series A and Series BPreferred Stock, the Company immediately completed a transaction with apublicly traded investment trust on the London Stock Exchange in which itreceived approximately $2.8 million, net of all expenses, in exchange forall of the 800,000 shares of its Series A Preferred Stock. Effective March 29,2004, the Company completed a second transaction with another publicly tradedinvestment trust on the London Stock Exchange in which it receivedapproximately $2.1 million in May 2004, net of all expenses, inexchange for 600,000 shares of its Series B Preferred Stock. As part ofthe Series B transaction, the remaining 150,000 shares of Series BPreferred Stock were released from escrow to the same publicly tradedinvestment trust, for which the Company received approximately $536,000, net ofall expenses.

 

The Series A and BPreferred Stock do not pay dividends and shall have no voting power, except asmay be provided by state law. The stated value of both the Series A and BPreferred Stock is $10.00 per share (“Stated Value”), and the liquidationpreference with respect to a share of the Series A and B Preferred Stockshall be its Stated Value. The Series A and B Preferred Stock shall, as toredemptions and distribution of assets, dissolution, or winding up of theCompany, rank (i) prior to any class of the Company’s common stock, (ii) priorto any class or series of capital stock hereafter created that, by its terms,ranks junior to the Series A and B preferred Stock, (iii) junior toany class or series of capital stock of the Company hereafter created which byits terms ranks senior to the Series A and B preferred stock. The Series Aand B Preferred Stock shall rank pari passu as to one another.

 

The Series A and BPreferred Stock may be converted at the option of the holder at any timefollowing two years from the Closing dates for the purchases of the preferredshares, which were March 3, 2004 and March 29, 2004, respectively.Except as specified in the Certificates of Designation, neither the holders ofthe Series A and Series B Preferred Stock nor the Company may demandthat the preferred shares be redeemed. In the event that the Company engages ina transaction or a series of transactions that cause it to consolidate or mergewith or into another entity, or permit any other entity to consolidate or mergewith or into it, or undergo a change in control, the Company may demand thatthe holders convert all shares of the Series A and B Preferred Stock intoshares of the Company’s common stock. If the holders do not comply with suchdemand, the Company may redeem all shares of the Series A and B PreferredStock at the Stated Value of each.

 

Each share of Series APreferred Stock is convertible into shares of the Company’s common stock, at avariable conversion ratio which is the lesser of (a) $4.00 as adjusted(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 dayspreceding the date of conversion, but, in no case, less than twenty-fivepercent (25.0%) of the Series A Fixed Conversion Price, as adjusted, or$1.00 per share. Based on the conversion ratio the holder of Series APreferred Stock will never receive more than 8,000,000 or less than 2,000,000shares of the Company’s common stock upon conversion of the Series APreferred Stock.

 

Each share of Series BPreferred Stock is convertible into shares of the Company’s common stock, at avariable conversion ratio which is the lesser of (a) $3.65 as adjusted(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 dayspreceding the date of conversion, but, in no case, less than twenty-seven andfour tenths percent (27.4%) of the Series B Fixed Conversion Price, as adjusted,or $1.00 per share. Based on the conversion ratio the holder of Series BPreferred Stock will never receive more than 7,500,000 or less than 2,054,795shares of the Company’s common stock upon conversion of the Series BPreferred Stock.

 

The purchaser of the Series APreferred Stock was granted an option to purchase additional shares of theCompany’s common stock equal to the difference between the number of shares ofcommon stock actually received upon conversion and the number of shares thatwould have been received at a conversion price of $1.82. The exercise priceshall be the Series A Fixed Conversion Price.

 

F-25

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**9.Stockholders’ Equity (Continued)**

 

The purchaser of the Series BPreferred Stock was granted an option to purchase additional shares of theCompany’s common stock equal to the difference between the number of shares ofcommon stock actually received upon conversion and the number of shares thatwould have been received at a conversion price of $1.82. The exercise priceshall be the Series B Fixed Conversion Price.

 

The Company determinedthat the intrinsic value of the beneficial conversion features embedded in the Series Aand Series B Preferred Stock exceeded the proceeds from these PreferredStock issuances. The Company accreted the value of the beneficial conversionfeature through equity and recorded a deemed dividend to preferredstockholders. These dividends amounted to $0, $0 and $6,200,005 for the threemonths ended March 31, 2008 and 2007 and the period from October 14,2000 (inception) through March 31, 2008, respectively, and are included inthe consolidated statements of operations. In April 2006, the holders ofboth the Series A and Series B Convertible Preferred Stock exercisedall of their conversion rights and converted 1,550,000 shares of ConvertiblePreferred Stock into 15,500,000 shares of common stock.

 

**Warrants**

 

A wholly-owned subsidiaryof the Company entered into a supply and distribution agreement (the “DistributionAgreement”) with a distributor dated July 10, 2001 that granted thedistributor the right to purchase up to 10% of the outstanding common stock ofthe Company for $1.00 per share should certain sales targets be achieved. Thewarrant was to expire on July 10, 2006. None of the sales targets havebeen achieved under the Distribution Agreement and as of December 10, 2004this Distribution Agreement was terminated and replaced by a new supply anddistribution agreement (the “New Agreement”). Under this New Agreement, thedistributor received a warrant to purchase 600,000 shares of O2Diesel’s commonstock 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 and$3.0 million Private Placements and the $2.3 million Private Placement anopportunity to exercise their warrants at the reduced price of $0.35 per share.On February 27, 2006, the Warrant Offering expired and the Companyreceived proceeds of $592,692 (after expenses) for the exercise of warrants topurchase 1,864,035 shares of common stock. Between May 31 and June 12,2006, several other existing warrant holders elected to exercise their warrantsat the contract price identified in their warrant documentation. Proceeds forthese exercises were $865,452 (after expenses) for the purchase of 1,287,857shares of common stock.

 

On April 27, 2007,the Company offered existing warrant holders an opportunity to exercise theirwarrants at the reduced price of $0.50 per share. If all eligible warrantholders were to exercise their warrants at the reduced price, the Company wouldreceive proceeds of approximately $4.3 million. The warrant offer wasoriginally set to expire on May 25, 2007, however on May 9, 2007, theCompany 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 tendertheir warrants, additional shares of Common Stock if the Company entersinto any agreement for the sale of shares of Common Stock at less than $0.50per share prior to June 8, 2008. The offer expired on June 8,2007, without any of the warrant holders exercising at the reduced price.

 

F-26

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

**9.Stockholders’ Equity (Continued)**

 

**Options**

 

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

 

The following table showsthe outstanding options granted under the 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                      |       |   | 7.5 |   |   |
| Exercised in  2005                                           |       | -     |       |                    |       |                      |       |   |   |   |
| Forfeited or  Expired                                        |       | -     |       |                    |       |                      |       |   |   |   |
| Outstanding at  December 31, 2005                       |       | 5,950,000                 |       |                    | $          | 1.50                      |       |   | 7.5 |   |   |
|                                                         |       |                      |       |                    |       |                      |       |   |   |   |
| Granted During  the Year Ended December 31, 2006        |       | 1,350,000                 |       |                    | $          | 1.28                      |       |   | 8.2 |   |   |
|                                                         |       | 200,000                   |       |                    | $          | 1.50                      |       |   | 8.2 |   |   |
|                                                         |       | 100,000                   |       |                    | $          | 0.71                      |       |   | 8.6 |   |   |
| Exercised During  the Year Ended December 31, 2006      |       | -     |       |                    |       |                      |       |   |   |   |
| Forfeited or  Expired                                        |       | (100,000                  | )          |                    | $          | 1.28                      |       |   |   |   |   |
| Outstanding at  December 31, 2006                       |       | 7,500,000                 |       |                    | $          | 1.43                      |       |   | 7.6 |   |   |
|                                                         |       |                      |       |                    |       |                      |       |   |   |   |
| Granted During  the Year Ended December 31, 2007        |       | 250,000                   |       |                    | $          | 1.50                      |       |   | 9.8 |   |   |
| Exercised During  the Year Ended December 31, 2007      |       | -     |       |                    |       |                      |       |   |   |   |
| Forfeited or  Expired                                        |       | (1,575,000                | )          |                    | $          | 1.48                      |       |   |   |   |   |
| Outstanding at  December 31, 2007                       |       | 6,175,000                 |       |                    | $          | 1.45                      |       |   | 7.8 |   |   |
|                                                         |       |                      |       |                    |       |                      |       |   |   |   |
| Granted During  the Three Months Ended March 31, 2008   |       | -     |       |                    |       |                      |       |   |   |   |
| Exercised During  the Three Months Ended March 31, 2008 |       | -     |       |                    |       |                      |       |   |   |   |
| Forfeited or  Expired                                        |       | (200,000                  | )          |                    | $          | 1.28                      |       |   |   |   |   |
| Outstanding at  March 31, 2008                          |       | 5,975,000                 |       |                    | $          | 1.45                      |       |   | 7.7 |   |   |
|                                                         |       |                      |       |                    |       |                      |       |   |   |   |
| Exercisable at  March 31, 2008                          |       | 5,616,125                 |       |                    | $          | 1.46                      |       |   | 7.7 |   |   |

 

**RestrictedStock Awards**

 

On November 4, 2004,the Company entered into an investor relations consulting agreement for a termof four years. In exchange for services, the Company awarded the consultant50,000 shares of restricted stock as settlement of this agreement, effective November 9,2007 and recognized $23,500 of consulting expense in 2007.

 

On September 20,2005, the Company entered into an investor relations consulting agreement for aterm of one year which the parties subsequently agreed to renew on an annualbasis. In exchange for services, the Company paid the consultant $7,250 permonth. In addition, the Company awarded the consultant 100,000 shares ofrestricted stock. As of March 31, 2008, the restrictions on all 100,000shares issued under this contract had lapsed and such shares were earned andable to be sold.  On March 31, 2008,the Company awarded 120,000 shares of restricted stock as final payment forservices rendered and terminated this agreement. The $36,238 of expense relatedto this award was offset entirely by the settlement of amounts previouslyaccrued for such services.  For the threemonths ended March 31, 2008 and 2007 and for the period October 14,2000 (inception) through March 31, 2008, the Company recognized $0, $0 and$81,500, respectively, of net expense in connection with these stock awards.

 

F-27

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**9.Stockholders’ Equity (Continued)**

 

On November 16,2006, the Board of Directors approved the grant of 500,000 shares of restrictedstock to a former officer, Mr. Roger, pursuant to the terms of the Company’s2004 Stock Incentive Plan and Mr. Roger’s employment agreement. The termsof the award were that the shares were to be issued on January 1, 2007with 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. Under the terms of theagreement, the receipt of shares was contingent on Mr. Roger remainingemployed by the Company on the date of vesting. In 2006, there was noFAS 123(R) expense for the grant of restricted stock.

 

On May 14, 2007, theCompany entered into an investor relations consulting agreement for a term oftwo months. In exchange for services, the Company paid the consultant a fee of$10,000. In addition, the Company awarded the consultant 50,000 shares ofrestricted stock. In connection with the stock award, the Company recognized$0, $0 and $27,000 of consulting expense for the three months ended March 31,2008 and 2007 and for the period October 14, 2000, (inception) through March 31,2008, respectively.

 

On May 16, 2007, theCompany entered into a second investor relations consulting agreement for aterm of six months. In exchange for services, the Company awarded theconsultant 440,000 shares of restricted stock. In connection with the stockaward, the Company recognized $0, $0 and $213,000 of consulting expense for thethree months ended March 31, 2008 and 2007 and for the period October 14,2000, (inception) through March 31, 2008, respectively. Pursuant to theterms of the consulting agreement, 220,000 shares, 120,000 shares and 100,000shares of the restricted stock were earned by the consultant on May 16,2007, July 16, 2007 and September 17, 2007, respectively. As March 31,2008, the restrictions on the 440,000 shares issued under this contract havelapsed and such shares were earned.

 

On August 1, 2007,the Company entered into a Separation Agreement with Mr. Roger. Pursuantto the Separation Agreement, all of Mr. Roger’s options vested as of thedate of the Separation Agreement and in accordance with the Incentive Plan, Mr. Rogerhad thirty days to exercise these options, which expired unexercised. Finally,166,667 of the remaining shares of Mr. Roger’s restricted stock vested onthe date of the Separation Agreement and 166,666 of the remaining shares willvest on July 31, 2008. Mr. Roger agreed not to sell or transfer theseshares until after that date.

 

The following schedulepresents shares of common stock issued and outstanding and reserved for futureissuance as of March 31, 2008:

 
| Common Shares  Outstanding                                                                    |   |       |   | 86,883,556  |
|-----------------------------------------------------------------------------------------------|--------|------------|--------|-------------|
|                                                                                          |   |       |   |        |
| Reserved For  Future Issuance                                                                 |   |       |   |        |
| Options granted  to officers, directors, employees and consultants                            |   | 5,975,000  |   |        |
| Unearned  restricted stock award to former officer                                            |   | 166,666    |   |        |
| Unearned common  stock issued for commitment shares                                           |   | 368,452    |   |        |
| Warrants                                                                                      |   | 12,683,997 |   | 19,194,115  |
|                                                                                          |   |       |   |        |
|                                                                                          |   |       |   |        |
|                                                                                          |   |       |   |        |
| Total shares issued and outstanding and reserved for  future issuance at March 31, 2008. |   |       |   | 106,077,671 |

 

F-28

 

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**Notesto Consolidated Financial Statements (Continued)**

**(Unaudited)**

 

**10. RelatedParty Transactions**

 

A company controlled by aformer Chairman of the Board provided office space, accounting and otherservices to the Company at a cost of approximately $2,500 per month, through June 2007,to the Company’s Irish subsidiary. For the three months ended March 31,2008 and 2007 and for the period October 14, 2000, (inception) through March 31,2008, the Company paid $0, $16,509, and $207,595, respectively, to the companycontrolled by the former Chairman. At March 31, 2008, there was no amountaccrued as a payable to this related party.

 

Included in otherreceivables at March 31, 2008 and December 31, 2007 is $24,408 and$15,611 which primarily represents travel advances made to employees. Includedin Accounts Payable at March 31, 2008 and December 31, 2007 is$223,806 and $150,486 which primarily represents directors’ fees and travelexpenses reimbursable to employees.

 

The Company has enteredinto two separate consulting contracts with two shareholders of its Braziliansubsidiary for the purpose of providing office rent and administrative servicesand in lieu of employment contracts with these two individuals. These twocontracts provide support significant to the operation of the Braziliansubsidiary. The company incurred expenses of $41,067, $34,342 and $662,020 forthe three months ended March 31, 2008 and 2007 and for the period October 14,2000 (inception) through March 31, 2008, respectively.

 

**11.Commitments**

 

**Operatingleases**

 

The Company leases officespace and certain office equipment under agreements that are accounted for asoperating leases. As of March 31, 2008, future minimum lease paymentsunder non-cancelable operating leases were as follows:

 

Operating Leases

 
| 2008  |   | $      | 105.374 |   |
|-------|--------|--------|---------|--------|
| 2009  |   | 15,400 |    |
| Total |   | $      | 120,774 |   |

 

Rent expense under theleases with unrelated parties was $49,100, $39,196 and $563,232 for the threemonths ended March 31, 2008 and 2007 and for the period October 14,2000 (inception) through March 1, 2008, respectively.

 

**12.Subsequent Events**

 

**YellTec Transaction**

 

On April 6, 2008,the Company entered into a Letter of Intent (the “YellTec Agreement”) toacquire all the outstanding shares of YellTec GmbH (“YellTec”), a Germancompany which specializes in biofuels distribution.  YellTec is focused on small to medium sizetruck fleets and operates an exclusively German-based network of its ownstrategically located fueling points.

 

The Company is acquiringall the outstanding shares of YellTec for €3 million, or $4.7 million atcurrent exchange rates and subject to a purchase price adjustment, and isissuing 5.3 million shares of the Company’s stock.  The Company is working with an internationalinvestment banking firm to identify potential investors for this transaction.

 

The common stock will beissued to the accredited investor in a transaction that will be exempt fromregistration pursuant to Section 4(2) of the Securities Act and/orRegulation D promulgated under the Securities Act.

 

F-29

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR RESULTS OF OPERATION**

 

**OVERVIEW**

 

**BusinessPlan**

 

The Company is classifiedas a development stage company as shown on its unaudited consolidated financialstatements for the period from inception (October 14, 2000) through March 31,2008.

 

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 Corporationeffective June 10, 2003, in contemplation of the reverse acquisition ofAAE Technologies International Plc (“AAE”). On July 15, 2003, O2Dieselacquired all of the issued and outstanding share capital of AAE in exchange for17,847,039 shares of its common stock (the “Offer”). As a result of thistransaction, the former shareholders of AAE acquired control of the combinedcompanies. The acquisition of AAE has been accounted for as a capitaltransaction followed by a recapitalization as AAE was considered to be theaccounting acquirer. Accordingly, the historical consolidated financialstatements of AAE are considered to be those of O2Diesel for all periodspresented.

 

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

 

Subsequent to the Offerand during 2003, the Company undertook an effort to raise an additional$3.5 million through a follow-on private placement. Pursuant to thefollow-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 wasclosed as of March 31, 2004.

 

On December 29,2004, the Company consummated a merger (the “Reincorporation Merger”) with andinto its wholly owned subsidiary, O2Diesel Delaware Corporation, a Delawarecorporation (“O2Diesel Delaware”), in order to reincorporate in the State ofDelaware (the “Reincorporation”). The Reincorporation Merger was affectedpursuant to an Agreement and Plan of Merger entered into between the Companyand O2Diesel Delaware on December 29, 2004. The Reincorporation wassubmitted to a vote of, and approved by, the Company’s shareholders at itsannual meeting held on August 16, 2004. As a result of theReincorporation, the legal domicile of the Company is now Delaware. The mergerbecame effective on December 31, 2004.

 

Since July 2003, theCompany has raised approximately $37 million for its operations.

 

**TransactionsDuring the First Quarter of 2008**

 

**ProEcoTransaction**

 

On January 12, 2007,the Company entered into a share exchange agreement (the “Share ExchangeAgreement”) with ProEco Energy Company, Inc. (“ProEco”) and itsshareholders (“ProEco Shareholders”) to acquire shares equal to 80% of theoutstanding capital stock of ProEco in exchange for approximately 9.2 millionshares 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 hadlimited operations to date, had been in the process of developing a newfuel-grade ethanol plant with planned capacity of 100 million gallons per yearto be built in two 50 million gallon trains (each a “Train “). Pursuant to theterms of the Agreement, ProEco Shareholders would receive 60% of theTransaction Shares at the time of the closing and would receive the remaining40% of the Transaction Shares in two equal installments upon the completion ofconstruction of the first Train (20%) and the commencement of construction ofthe final Train (20%). The remaining 40% of the Transaction Shares would beheld in escrow until the conditions for their release had been met. The partiesintended the transaction to qualify as a tax-free reorganization under Section 368(a) ofthe U.S. Internal Revenue Code of 1986, as amended (the “Code”).

 

The Agreement requiredProEco to complete a number of steps toward completion of the Ethanol Plantproject in order for the closing of the share exchange to occur. At the time ofthe closing, ProEco was required to have entered into a definitive engineering,procurement and construction (“EPC”) contract with a reputable firm withextensive experience in implementing and completing projects similar to theEthanol Plant project and executed marketing agreements for the sale of theproduction of the Ethanol Plant as well as corn feedstock. Under the terms ofthe share exchange agreement, ProEco was responsible for having the EthanolPlant designated as a facility nameplated, or certified, as producing ethanolat a level of at least 100 million gallons of production a year.

 

1

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

As a condition to theclosing of the ProEco share exchange, the Company was obligated to secure thefinancing necessary to complete the construction costs to build the EthanolPlant. Accordingly, the Company was required to raise $60 to $70million in debt and between $30 and $40 million in equity in the first quarterof 2008 for each train.

 

Prior to closing, theCompany and the ProEco Shareholders were to enter into a stockholder agreementthat would, among other things, impose restrictions on the transfer of theTransaction Shares.

 

The Common Stock was tobe issued to the ProEco Shareholders in a transaction that would be exempt fromthe registration requirement pursuant to Section 4(2) of theSecurities Act and under Regulation D promulgated under the SecuritiesAct.

 

Under the terms of theletter of intent for the share exchange agreement, the Company agreed to enterinto a secured loan agreement with ProEco for the purposes of financing thepurchase options for the land to be used for the ethanol plant and certainengineering and permitting work required for the closing of the ProEco shareexchange.  The annual interest rate onthe loan is 7% and the maturity date of the loan was December 15, 2007.

 

Current trends in theethanol industry have seen increases in the price of corn and other feedstocksas well as a decline in the average selling price of ethanol.  For a number of new plant constructionprojects, the lack of EPC contractor availability has resulted in increasedcosts and delays in completion dates.  OnJanuary 8, 2008, the Company announced that due to unfavorable marketconditions for raising capital for ethanol plants, the Company and ProEco hadentered into an agreement to extend the Share Exchange Agreement and thematurity date of the loan from the Company to ProEco until January 31,2008.  These agreements were subsequentlyextended again until February 29, 2008. On March 19, 2008, the Company and ProEco entered into a letteragreement terminating the Share Exchange Agreement and extending the maturitydate of the loan from February 29, 2008 until November 30, 2008.  The Company and ProEco have agreed tocontinue to develop the Ethanol Plant when conditions in the capital marketsimprove.  Management has evaluated thisproject based on its assessment of the challenges to financing projects of thisnature, posed by the present debt and equity markets, as well as the limitedlikelihood that a buyer will be identified for this project in the near future.  Accordingly the Company believes that it isprudent not to assign a value to this asset. As such, an impairment charge of $1,288,614 was warranted and thisadjustment was recorded in December 2007.

 

The following tablesummarizes the significant assets and liabilities of ProEco as of March 31,2008 and December 31, 2007:

 
| Cash             |   | $       | 8,310  |   |
|------------------|--------|---------|--------|--------|
| Accounts payable |   | 351,005 |   |
| Accrued expenses |   | 31,304  |   |

 

ProEco expenses,including the $1,288,614 impairment charge and after elimination ofintercompany transactions, of $15,000, $0 and $1,704,287 for the three monthsended March 31, 2008 and a 2007 and the period October 14, 2000(inception) through March 31, 2008, respectively, are also reflected inthe Company’s consolidated statements of operations.

 

**Energenics Transactions**

 

On October 17, 2007,the Company entered into a private financing agreement and a joint venturetransaction with Energenics Holdings Pte Ltd (“Energenics Holdings”) toprovide funding and commercial support to develop the Asian market for O2DieselTM , the Company’s ethanol diesel fuel blend.

 

The parties entered intoa Common Stock and Warrant Purchase Agreement (the “Energenics Agreement”), asamended on December 10, 2007 (the “Amendment”), pursuant to whichEnergenics Holdings agreed to purchase 3,333,333 shares of the Company’s commonstock in a private placement, for total proceeds of approximately$1.25 million. The effective per share price of $0.375 represents 121% ofthe market price on the AMEX on the day prior to the signing of the Amendment.As part of the transaction, the Company agreed to issue a warrant to purchase1,666,667 shares of common stock at an exercise price of $0.375 per share,which warrant will be issued upon the closing of the transactions contemplatedby the Energenics Agreement and shall be exercisable from the date that is sixmonths following the date of issuance until October 17, 2012 (“InvestmentWarrant”).

 

The parties also enteredinto a Shareholders Agreement in which Energenics Holdings and the Company willjointly develop the market for O2Diesel TM  in Asia through O2Diesel Asia Limited (“O2DieselAsia”). Energenics agreed to pay the Company $750,000 for a fifty percent (50%)equity interest in O2Diesel Asia. The balance of the interest in O2Diesel Asiawill be held by O2Diesel Europe Limited, a wholly-owned subsidiary of theCompany. For the past year, pursuant to the Supply and Distribution Agreement,dated September 15, 2006, O2Diesel has supplied its additive to Energenicsfor the blending and distribution of O2Diesel TM  in the Asian Pacific and South Asia.

 

2

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

The parties entered intoa License agreement whereby O2Diesel Europe Limited (formerly AAE TechnologiesInternational Plc) will license to O2Diesel Asia certain patents andknow-how that are required to make and sell O2Diesel TM  in the territory in exchange for certainpayments pursuant to the Shareholders Agreement. In addition, the Companyentered into a similar License agreement with O2Diesel Asia, pursuant to whichthe Company will pay to O2Diesel Asia a royalty based on sales of the Company’sproduct in the territory.

 

As part of thetransaction, upon the purchase of certain quantities of O2D05 or theequivalent, the Company will also issue a warrant to purchase 1,500,000 sharesof common stock at an exercise price of $0.375 per share, which warrant shallbe exercisable during the period from the date of issuance until October 17,2012 (“JV Warrant”).

 

Also, as part of thetransaction, upon the achievement by Energenics Holdings of certain levels ofadditional purchases of O2D05 or the equivalent, the Company will issueadditional warrants to purchase up to an aggregate of 6,500,000 shares of commonstock at a price per share equal to the lesser of $0.375 or 121% of the closingprice per share (rounded to the nearest cent) of the Company’s common stock ona recognized exchange on which these shares are traded on the date suchwarrants are earned (“Market Development Warrants,” and, collectively with theInvestment Warrant and the JV Warrant, the “Warrants”). The Market DevelopmentWarrants are exercisable from the date of issuance to October 17, 2012.

 

Due to market conditionsin the global credit markets, Energenics Holdings has funded only a portion ofthis transaction.  The Company hasreceived $1,250,000 in two deposits on November 14, 2007 and December 21,2007.  The Company and Energenics arecurrently renegotiating the terms of this transaction and the final payment of$750,000.  The Company anticipatesclosing this transaction during the second quarter of 2008.

 

**KL Process Transaction**

 

On March 11, 2008,the Company’s wholly owned subsidiary, O2Diesel Europe, Plc (“O2Diesel Europe”)entered into an exclusive Technology License and Services Agreement (the “KLAgreement”) with KL Process Design Group, LLC (“KL”) whereby O2Diesel Europeobtained an exclusive license to use, exploit and sublicense certain KLintellectual property, know-how and processes for the production and sale ofethanol from feedstocks other than simple sugars and starches (the “Product”).  KL granted this license to O2Diesel Europe onan exclusive basis in Europe, India, Russia and other rapidly developing globalmarkets.  Pursuant to the Agreement, KLalso agreed to provide certain services related to the design and constructionof production plants necessary to produce the Product.

 

As part of the KLAgreement, the Company agreed to issue 1,000,000 shares of the Company’s commonstock to KL as consideration for the license, as well as certain royalty anddesign services fees.  The common stockwill be issued to the accredited investor in a transaction that will be exemptfrom registration pursuant to Section 4(2) of the Securities Actand/or Regulation D promulgated under the Securities Act.

 

**YellTec Transaction**

 

On April 6, 2008,the Company entered into a Letter of Intent (the “Agreement”) to acquire allthe outstanding shares of YellTec GmbH (“YellTec”), a German company whichspecializes in biofuels distribution. YellTec is focused on small to medium size truck fleets and operates anexclusively German based network of its own strategically located fuelingpoints.

 

The Company is acquiringall the outstanding shares of YellTec for €3 million or $4.7 million at currentexchange rates subject to a purchase price adjustment as described in theAgreement and is issuing 5.3 million shares of the Company’s stock.  The Company is working with an internationalinvestment banking firm to identify potential investors for this transaction.

 

The common stock will beissued to the accredited investor in a transaction that will be exempt fromregistration pursuant to Section 4(2) of the Securities Act and/orRegulation D promulgated under the Securities Act.

 

A copy of the Agreementwill be filed as an exhibit to the Company’s Form 10-Q on or about August 15,2008.

 

**Delistingof Common Stock on AMEX**

 

On June 15, 2004,the American Stock Exchange (“AMEX” or “Exchange”) approved an application tolist 46,518,898 shares of our common stock under the symbol OTD. Subsequent tothis date, the Exchange has approved additional applications to list 74,173,483more shares of our common stock so that the total number of shares approved forlisting is 120,692,381. Our shares began to trade on the Exchange on July 1,2004.

 

3

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

The Company’s auditedconsolidated financial statements for the year ended December 31, 2007,were prepared on a going concern basis, which contemplates the realization ofassets and the settlement of liabilities and commitments in the normal courseof business. Our independent registered public accounting firm included anexplanatory paragraph in their report on the December 31, 2007 auditedconsolidated financial statements to highlight that the Company’s accumulatedlosses and working capital deficit raised substantial doubt about the Company’sability to continue as a going concern.

 

The Company’s unauditedfinancial statements for the three months ended March 31, 2008, have beenprepared on a going concern basis, which contemplates the realization of assetsand the settlement of liabilities and commitments in the normal course ofbusiness.  If the Company were tocontinue to incur losses without additional funding and were to fail tocontinue as a going concern, then its assets and liabilities would be requiredto be stated on a liquidation basis which would differ significantly from thegoing concern basis.

 

At March 31, 2008,the Company had negative working capital of $453,401, of which $1,251,044 wasrestricted in use to operational costs associated with developing markets inEurope, and had accumulated losses of $45,403,588.  At December 31, 2007, the Company hadpositive working capital of $848,207, of which $2,333,959 was restricted in useto operational costs associated with developing markets in Europe, and hadaccumulated losses of $43,912,832.

 

The Company was notifiedin December 2004 by the AMEX that it was not in compliance with thelisting standards of the Exchange because it lacked the requisite amount ofstockholders’ equity. AMEX requires that minimum levels of stockholders’ equitybe maintained. O2Diesel was not in compliance because its stockholders’ equityhad dropped below the required minimums, and it had experienced continuinglosses for the past four years. In order to return to full compliance, O2Dieselneeded to have stockholders’ equity of $6.0 million by June 2006 andto maintain this level going forward.

 

In accordance with theprocedures of the Exchange, we filed a plan (“Plan”) with it to demonstrate thesteps 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 givenuntil June 2006 in which to regain compliance with the Exchange’s listingrules. To achieve that level of stockholders’ equity, we anticipated having toraise a total of approximately $10.0 million in new equity during 2005. InDecember 2005, the Company determined that it could not meet certainconditions of the Plan and met with representatives of the AMEX to discuss theneed to develop an amended plan to demonstrate how the Company would be in complianceby June 2006. During 2006, as part of its efforts to meet theserequirements, the Company closed an offer to existing warrant holders toexercise their warrants at a reduced price for proceeds of approximately $1.5million (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 hadregained compliance with AMEX listing requirements. At December 31, 2006,the Company was in compliance with AMEX listing requirements, but for theperiod ended March 31, 2007, the Company was not able to meet the listingrequirements. On June 29, 2007, the Company was notified by AMEX that itwas not in compliance with the listing standards of the Exchange because it lackedthe requisite amount of stockholders’ equity. The Company was asked to submit a plan by July 27, 2007 advisingAMEX of actions the Company would be taking to bring it into compliance withthe continued listing standards by December 29, 2008.

 

On July 27, 2007,the Company filed a plan with the Exchange describing the steps it planned totake to return to full compliance.  TheCompany had entered into a common stock purchase agreement with Fusion CapitalFund II, LLC to raise up to $10 million in new equity over a twenty-five monthperiod starting February 16, 2007. Also the Company announced a private placement in which we raised anadditional $2.52 million in July and August 2007.  As noted below, the Company intended to raiseadditional new equity in conjunction with the acquisition of the ProEco EnergyCompany.  We believed these actions wouldenable us to meet or exceed the equity requirements of the Exchange.

 

On September 13,2007, the Company received a written notice from the AMEX indicating that AMEXhad reviewed and accepted the Company’s plan to regain listing qualificationscompliance.  With the acceptance of theplan, the Company was able to continue its listing during the plan periodpursuant to an extension granted until December 29, 2008.  The AMEX notice also advised the Companythat, in addition to the previously disclosed deficiency with respect to Section 1006(a)(iii) ofthe AMEX Company Guide, it had triggered an additional deficiency with respectto Section 1003(a)(ii) of the AMEX Company Guide which requireslisted companies to have at least $4.0 million of stockholders’ equity when ithas sustained losses from continuing operations and/or net losses in its fourmost recent fiscal years.

 

Under the terms of thenotice from AMEX, the Company was to continue to provide AMEX staff withupdates regarding initiatives set forth in its plan of compliance.  The Company has been subject to periodicreview by AMEX staff during the interim period. If the Company was not in compliance on December 29, 2008, or theCompany did not make progress consistent with the plan during the interimperiod, the AMEX would likely initiate procedures to de-list the Company’scommon stock. If the Company’s common stock were to be de-listed by the AMEX,the Company believed its shares would continue to be traded as a bulletin boardstock.

 

The consolidatedfinancial statements in this report do not include any adjustments to reflectother anticipated private placements or the possible future effects of therecoverability and classification of assets or the amounts and classificationof liabilities that may result should management be unsuccessful in obtainingfinancing on terms acceptable to the Company.

 

4

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

As described previouslyin the section, the Company announced that due to the unfavorable marketconditions for raising capital for ethanol plants, the Company and ProEcoentered into a letter agreement terminating the Share Exchange Agreement andextending the maturity date of the loan from February 29, 2008 until November 30,2008.  The Company and ProEco have agreedto continue to develop the Ethanol Plant when conditions in the capital marketsimprove.

 

On February 7, 2008,the Company received notice from the staff of the AMEX that due to the deferralof the ProEco project, the Company was no longer demonstrating progressconsistent with the July 27, 2007 plan and had determined to proceed with anapplication to the Securities and Exchange Commission to remove the commonstock of the Company from listing and registration on AMEX. This action, whichwas appealed by the Company, was taken because the Company is not in compliancewith Section 1003(a)(iii) of the AMEX Company Guide, in that itsstockholders’ equity is less than $6 million and it has sustained losses fromcontinuing operations and/or net losses in its five most recent fiscal years.In addition, the Company is not in compliance with Section 1003(a)(ii) asits stockholders’ equity is less than $4 million and it has sustainedlosses from continuing operations and/or net losses in three out of four of itsmost recent fiscal years.

 

On February 12,2008, the Company appealed the delisting determination by requesting an oralhearing to present its plan, its progress in achieving the plan and maintainingits AMEX listing. On April 4, 2008,the Company received notice from AMEXthat it was not in compliance with Section 1003(a)(i) in that the Company’sstockholders’ equity is less than $2 million and it has sustained losses fromcontinuing operations and/or net losses in two of its three most recent fiscalyears and Section 1003(a)(iv) which concerns the delisting of thesecurities of a company based on the amount of such losses and the impairmentof its financial condition.  Subsequentto an oral hearing on April 15, 2008, the Company received notice on April 21,2008 from AMEX indicating its determination to prohibit the continued listingof the Company’s common stock on the Exchange and to initiate delistingproceedings.

 

On April 28, 2008the Company announced that it began trading on the Pink Sheet ElectronicQuotation Service under the trading symbol OTOD.PK.

 

**Operations**

 

During the first quarterof 2008, we continued our efforts to generate sales to our targeted fleetcustomers in North America, South America and India, as well as our efforts todevelop targeted demonstrations in Europe.

 

*North America*

 

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

 

     Current and projected quantity of dieselfuel consumption;

 

     High population centers under strict airquality regulations;

 

     Municipal transit and school bus fleetswith an emphasis on public policy and a positive environmental image;

 

     Large concentrations of urban-based,centrally fueled fleets of trucks and buses;

 

     Off-road construction equipment;

 

     Diesel equipment used by port facilitiesand large-scale mining operations; and

 

     Military installations in non-combatvehicles

 

In the U.S., O2Diesel’sfirst quarter sales and marketing efforts for fleet sales were focused in thestate of California and in the Midwest. The Company continued its commercial activities at the Port of LongBeach and the pursuit of additional opportunities in this market segment at theports of Oakland and Los Angeles. The Company expanded its test demonstrationwith a USAF base in Nevada and had nearly completed a second demonstration atMinot Air Force Base (North Dakota) in which the Company’s technology wasproven to be successful under extreme cold weather conditions.  During the second quarter of 2008, theCompany will add a third test demonstration for the Air Force at a base inLouisiana during which the Company’s technology will be tested under extremehumidity conditions.  It is expected thatthis third test will be the final demonstration required by the Air Force inorder to implement a formal purchasing specification during the third quarterof this year.

 

We also continued todevote resources to our CityHomeTM demonstration program as a means ofdocumenting operating performance data. CityHomeTM is a marketing and sales initiative directed at city transitagencies across the United States as an opportunity to

 

5

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

improve air quality inurban locations. This program stresses the environmental benefits of our fueland is designed to allow municipal transit authorities to convert their fleetsto O2DieselTM without having to pay the higher costs of our fuel.

 

Through an innovativecost sharing concept with companies that wish to be good corporate citizens(sponsors), we have designed a program which permits the municipalities topurchase our fuel at costs which are the same as what they pay for regulardiesel fuel. Corporate sponsors, generally with a national or internationalpresence, will pay sponsorship fees to O2Diesel to take part in a clean airprogram for one or more of the communities participating in a CityHomeTMprogram. In return for sponsorship payments, each sponsor will be given accessto currently unused advertising space on buses and other advertising assetsowned by the municipality. Sponsorship fees will become additional revenue forus and will be recognized as such when the related advertising is displayed andall other criteria for revenue recognition have been met. Costs that areintended to be supported by the sponsorship fees are recorded separately in therelated expense line in our statement of operations. With regard to theadvertising space, since we have been unable to assess the fair market value ofthe advertising space received, we assign no value to the space at the time ofthe receipt. We are recognizing the value associated with the advertising spacewhen we enter into a contractual arrangement with a third party. The Companywill consider assigning a fair value to the advertising space received at thetime of the initial sale when such fair value is more readily determinable, basedupon a history of cash transactions.

 

In the first quarter of2008, we had a CityHomeTM installation with one municipal bus fleet as well asseveral small school bus fleets in Chicago and South Dakota.  To date, we have used this initiative as acomponent of our test/demonstration strategy and have been successful inattracting fuel distributors to work with us in getting this initiativestarted. However, while we have received sponsorship funding for severalCityHomeTM programs, the fleet demonstrations executed under this program haverequired significant financial support from the Company. As a result, we havelimited new CityHomeTM programs to instances where we are assured of a level ofsponsorship funding needed to cover all expenses of the demonstration. TheCompany’s future involvement with the CityHomeTM program has thus been reducedonly to programs that can be considered cost neutral.

 

We continued our effortsto support and improve the logistics network required for the delivery ofO2DieselTM to fleet and CityHomeTM customers during the first quarter. Theseefforts are focused on developing strategic relationships with ethanolproducers and distributors in order to improve both quality consistency andprice stability. As of March 31, 2008, the Company maintained its supplyagreement with an ethanol industry group to supply limited amounts of ethanolat preferential pricing for our Midwestern customers.

 

During the latter half of2007, the U.S. ethanol industry experienced several economic and logisticalchallenges to the general expansion of production capacity.  The prices of various ethanol feedstocks,most notably corn, have increased while, at the same time, ethanol prices haveseen a general decline as new production capacity comes on line.  In addition, the demands on experienced EPCcontractors have increased, particularly with the need for qualified skilledlabor to build new plants.  As aconsequence, many new projects have experienced increased construction costsand project delays at a time when the profitability of the industry is beingtested.  At the end of the year, marketconditions for raising capital for ethanol plants had become so unfavorablethat the Company announced its decision to delay the project with ProEco todevelop an ethanol plant until conditions in the capital markets improve.

 

We are continuing aseries of product tests and demonstrations that relate directly to obtainingregulatory approval for O2DieselTM and which are designed to meet the needs ofour targeted customers. During the quarter ended March 31, 2008, theCompany continued its efforts to register O2DieselTM fuel with the EPA and tocomplete the protocols to allow O2DieselTM to be classified as a CaliforniaDiesel Emissions Control Strategy (DECS) by the California Air Resources Board.

 

In addition, we continuedto develop a revised ballot for incorporation of our fuel as an AmericanSociety for Testing and Materials (ASTM) specification. This revision is basedon the results of the initial voting on the original ballot submitted in December 2006as well as the subsequent ballot submitted in December 2007. The 2007ballot showed a reduced number of negative votes which the task force hascontinued to respond to.  A member of theCompany serves as the chairman of the subcommittee tasked with revising thisballot and the revision will be re-submitted during the second quarter of 2008so that it can be discussed and voted on during the June 2008 ASTMinternational meeting.

 

Finally, during the firstquarter we continued to develop contract proposals for submission to the Departmentof Energy and the Department of Defense to utilize the $2.6 million ofavailable appropriations received in prior years. These appropriations wereawarded for the purpose of continued testing and verification of O2DieselTM,including the requirements of both DECS and the U.S. military. The workundertaken for our regulatory approvals has taken more time than originallyanticipated and, while we continue our efforts in these areas, it is notpossible to predict when these final approvals will be obtained.

 

*South America*

 

In Brazil, the roll outof our product has been much slower than planned, despite the fact that we havesucceeded in verifying our technology in several earlier demonstrationfleets.  The cost of ethanol in Brazilhas shown seasonal market fluctuations, which has made it difficult to produceour blended fuel at a consistently cost competitive level.  Also, obtaining government approvals andgaining market awareness has taken longer than we anticipated.  In response to these issues, we have made adecision to follow a less

 

6

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

aggressive marketingstrategy for Brazil and taken steps to reduce our overhead.  We are targeting customers in this market ona very focused basis, supporting them with a small consulting staff thatperforms our marketing and technical functions. Our marketing plans have been scaled back until we have a solid base ofcustomers.  In general, these will bemiller fleets (sugar and ethanol producers), municipal bus and other fleets,and to a lesser extent centrally fueled truck fleets.

 

Brazil’s fueldistribution system is more concentrated than in the U.S. As a consequence,O2Diesel must join with one or more large fuel distributors that can blend anddeliver O2DieselTM to customers in Brazil. O2Diesel currently cooperates on anon-exclusive basis with Brazil’s largest fuel distributor, BR, thedistribution arm of the state-owned mineral oil company Petrobrás. Failure toattract additional distribution partners to cover other parts of Brazil willlikely set back our timetable for achieving market penetration in that country.

 

During the first quarterof 2008, we continued our support of the municipal bus fleet in Curitiba.  We have seen a reduction in the market priceof ethanol during this time period. However, just as in the U.S., we have found that commercial success inBrazil will depend on reliable, cost competitive supplies of ethanol.  It is the Company’s intention to identifystrategic partners in the ethanol industry in Brazil and throughout SouthAmerica in order to negotiate such supply contracts.

 

In 2007, the Companyannounced the appointment of Fair Energy, S.A. as our distributor for severalnew markets in Central and South America. The Company has targeted demonstration programs in Columbia, Paraguayand Bolivia for implementation over the next several quarters.  The first of these demonstrations was startedin the fourth quarter of 2007 in Anunción, Paraguay’s capital and wassuccessfully completed during the quarter ended March 31, 2008.  The Company is currently waiting to see if thegovernment will require expanded use of the fuel in that country in 2008.

 

While South Americaremains an important market, the timing of expanded commercial activity herecontinues to be slower than anticipated and the Company cannot predict whenthis will occur.

 

*Europe*

 

During the first quarterof 2008, the Company continued its efforts to define the EU regulatoryrequirements and to identify market opportunities for testing and potentialcommercialization.  Our efforts in thisregion focused on developing fuel blending capability, identify flame arrestorand other hardware requirements for fleet fueling, working with local and EUregulators to clarify the application of existing regulations to ethanol-dieselas an alternative fuel, establishing procedures to be used to manage fleetconversions to our fuel and discussing test demonstration opportunities.  The Company continued its demonstrationprograms with municipal bus fleets in France (Veolia) and Spain (Tussam).  These demonstrations are funded by governmentgrants and the Company.  Upon successfulcompletion of these demonstrations, it is anticipated that the Company willhave fulfilled the requirements to be able to market O2DieselTM in thesecountries on a commercial basis.  We haveidentified several additional fleet demonstration opportunities in Spain, theNetherlands and Belgium.  We expect theseor other potential customers to develop into new demonstration programs in2008.

 

On March 11, 2008,the Company announced that its wholly owned subsidiary, O2Diesel Europe, PLC,had signed the KL Agreement with KL to develop the next generation of ethanolproduction known as Cellulosed-Based Ethanol (CBE).  The agreement secures the Company’s rights toexpand KL’s cellulosic to ethanol production technology in Europe, India,Russia and other rapidly developing global markets.  The Company views this agreement as asignificant strategic opportunity to participate in the development of secondgeneration renewable fuels in markets which are facing immediate regulatoryrequirements to replace traditional fossil fuels, such as the European Union.

 

On April 6, 2008,the Company announced that it had entered into a Letter of Intent to acquireYellTec GmbH (“YellTec”), a German company which specializes in biofuelsdistribution.  YellTec is focused onsmall to medium size truck fleets and operates an exclusively German basednetwork of its own strategically located fueling points throughout thatcountry.

 

The Company believes thatthese two transactions represent important steps in achieving its strategy ofexpanding its participation in the broader biofuels industry as well asvertically integrating and controlling the cost of the ethanol fuel component forO2DieselTM.

 

*Asia*

 

Our exclusive distributorin this region, Energenics, continued its efforts to expand its participationwith its first large municipal bus fleet in Karnataka, India.  The pace of the conversion of the remainderof this fleet during the first quarter was slower than expected which reducedorders for our product. Energenics has continued to target additional large busfleets in the state of Maharashtra, India.

 

Technical and LogisticalIssues

 

Significant technical andlogistical issues continued to challenge our ability to generate sales in thefirst quarter of 2008. While we have made substantial progress in addressingthese challenges, they have impeded our efforts to commercialize O2DieselTMfuel. In general, these challenges fall into the following categories: (1) logisticsof delivering and dispensing O2DieselTM fuel, (2) sourcing and installationof flame arrestors and other devices in vehicles and storage facilities, (3) negotiatingreliable, price-competitive

 

7

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

supplies of fuel gradeethanol and (4) obtaining regulatory approval and an industry acceptedspecification for our “e-diesel” (ethanol-diesel) fuel. O2Diesel hasimplemented several strategies to meet these challenges and has undertaken avariety of activities to overcome them and to position O2DieselTM as a premiumclean-burning fuel.

 

*(1) ***Logistics of delivery, storing and dispensing O2DieselTMfuel:**    We have signed distribution agreementswith nineteen jobbers, who in turn have centrally fueled fleets as theircustomers. We sell additive directly to these jobbers and, when required,assist them in locating ethanol supplies in order to blend these componentswith diesel and then sell our fuel to their customers. Alternatively, our salesforce plans to sell our additive directly to companies, governmental portfacilities and others that operate large centrally fueled fleets. To date, suchcustomers have included centrally fueled truck fleets and cargo handlingfacilities at a major port, however our sales force plans to market to bus fleets,construction fleets, municipalities, and agricultural users. In thesetransactions, the Company maintains a similar working relationship with thecustomer’s blending facilities as it does with third party jobbers. Whether wesell to the jobber or directly to the fleet customer, a key part of therelationship is to provide safety and technical training regarding the use ofthe fuel. In addition, our technical staff also works with customers to insurethat its storage facilities are clean and are compatible for storing anddispensing O2Diesel TM .

 

*(2) ***Sourcing and installation of flame arrestors and otherdevices:**    As part of the process by whichO2DieselTM was approved for sale in California, the California AirResources Board established several conditions that we must adhere to on anongoing basis. An important condition is that all storage tanks in whichO2Diesel is stored and all vehicles that use the fuel must be fitted withdevices know as flame arrestors. These are safety devices which are intended toprevent a fire in case a spark or other type of ignition might inadvertentlyenter the fill inlet of a fuel tank. In 2004 and 2005, this issue proved to bea serious obstacle and negatively impacted our ability to efficientlycommercialize our technology in the U.S. Even though this technology had beenused for many years, flame arrestors in the required sizes and designs were notyet available as an “off the shelf” item for use with our fuel at that time. Inaddition, the Company was required to conduct significant research anddevelopment efforts to identify (and in some cases design) flame arrestors,adaptors, primer pumps and other equipment for vehicles that use O2Diesel TM  in different climates and driving conditions.Since that time, the flame arrestor challenge has largely been resolved for thevehicles within O2Diesel’s target markets. Our technical staff works closelywith each customer with regard to purchasing and installing flame arrestors andother devices for customer vehicles and storage facilities. We will work withcustomers to source and install these devices either directly or in asupervisory role

 

*(3) ***Negotiating reliable, price-competitive supplies offuel grade ethanol**:    We have confirmed that itis important to carefully select ethanol suppliers, because there is a widerange of fuel grade ethanol in the marketplace. It is critical that the ethanolcomponent of O2Diesel TM  beof a consistently high quality and that it meet certain other specifications.We continue to work closely with the industry to identify ethanol suppliers whomeet our criteria. In 2008, we maintained a contract with an ethanol industrygroup to provide a supply of limited amounts of ethanol at preferential pricingfor our Midwestern customers. In addition, the Company announced its intentionto purchase a controlling interest in ProEco, an engineering company that isintending to build a new ethanol manufacturing facility in South Dakota. Whilethis project has been deferred due to conditions in the financing markets forsuch construction projects, it remains the Company’s intention to obtainownership interest in ethanol producing facilities so that we can assurecompetitively priced, high quality ethanol for use in our commercializationefforts.

 

In order to ensure fuelquality, we have developed a quality control function that constantly tests theethanol, the diesel blended with our additive and the final blended fuel usedby our customers. We have established our own laboratory facility to supportand enhance our quality control standards, as well as to carry out the teststhat are necessary to prepare a fleet for conversion to use O2DieselTM.Additionally, the Company has installed several testing devices in the field sothat samples can be evaluated more efficiently than with a centralizedlaboratory alone.

 

*(4) ***Obtaining regulatory approval and an industry acceptedspecification for our “e-diesel” (ethanol-diesel) fuel:** Aspreviously described in the Government Approvals section, the Company iscontinuing its efforts to certify its additives and O2Diesel TM  blends under the requirements of the EPA, theCARB and the ASTM. Our progress with these certification requirements willsupport our efforts to develop an alternative fuel specification for the DoD. Obtainingeach of these approvals is critical to successful commercialization of theCompany’s products.

 

The Company has takenseveral steps since 2005 to overcome these problems and to support theintroduction of O2DieselTM fuel to new customer opportunities.First, we have assembled documentation regarding the design requirements offlame arrestors and equipment used in our markets to serve as a basis for acatalogue of flame arrestors and parts that can be used for a wide variety ofengine/vehicle types and customer applications. We have identified severalequipment vendors who we now work with so that needed equipment can bedelivered to customer locations quickly and at competitive prices. To supportthese efforts further, we have developed a modest parts inventory at ourlaboratory facility so that in the event of an emergency, required parts can besupplied to our customers. Second, we have developed a checklist of proceduresto be used by our technicians (in conjunction with our customer) to prepare acomprehensive fleet profile of hardware requirements, tank cleaning proceduresand the time required to perform the work necessary to bring a fleet on-line.In addition, we have developed a training program that will enable ourtechnicians to teach our

 

8

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

customers’ fleetmaintenance staff about handling and storing O2Diesel TM fuel, fleetmodification and maintenance issues that can be expected. Third, to support ourimplementation efforts, we commissioned a third party engineering consultingfirm to review our written safety training procedures as well as to conducton-site reviews of four of our customer locations in order to evaluate the adequacyof the training and the quality of safety procedure implementation. The ensuingreport from the consultant indicated that our safety program requirements werewell conceived and were being followed quite closely at all locations.Additional safety procedures to enhance this program continue to be evaluated.

 

        Allof these issues have led to greater lead times than expected to convert fleetsfrom using regular diesel to O2DieselTM. In fact, we have seen thatthe time it takes to do the conversion work can be the most important factor inbringing on more customers to use our fuel. Other factors, such as theavailability of the customer’s vehicles for conversion, the degree ofparticipation provided by the customer’s maintenance employees and the flexibilityprovided to O2Diesel employees in assisting the implementation process (due tounion, insurance or safety reasons) can all add to the length of time toaccomplish these conversion tasks. The Company anticipates that the workcompleted since 2005 will allow us to bring all of these factors into theimplementation planning process so that we can avoid the costs and delays weexperienced in the past.

 

        Anotherchallenge to our commercialization strategy in 2008 has been the price andavailability of ethanol. The Company has seen that even with a reliablesupplier, the price of this commodity can be volatile as a result of a numberof factors, such as the overall supply and demand, the level of governmentsupport and the availability and the price of competing products. For example,starting in the second quarter of 2006, many petroleum refiners began replacingmethyl tertiary butyl ether (MTBE) in gasoline with ethanol. This replacementhas caused the demand for ethanol to increase dramatically, with acorresponding increase in its price. Similarly, the demand for corn hasincreased significantly, since this commodity is the primary ingredient in theproduction of ethanol. In addition, since most ethanol is transported by rail,freight costs continue to play a larger role in its price, particularly whenthe end users are geographically distant from the production facilities. Whileproduction quantities of ethanol have continued to increase, the rise in itsproduction and distribution costs have made the cost of O2DieselTMincrease in relation to convention diesel fuel throughout 2007. It is theCompany’s strategy going forward to help control the costs of ethanol bycontinuing our contract with the ethanol industry group at preferred prices andcontinuing our efforts to acquire production capacity from projects like theProEco acquisition.

 

        Thesechallenges have presented significant hurdles to commercializing ourtechnology. In many cases, we have overcome these obstacles by the applicationof technical resources, payments to support our customers and a high level ofcustomer service. All of this has been time-consuming and has slowed ourability to bring our product to market. But it has also created a base ofknowledge which is helpful as we continue our efforts to commercialize ourtechnology in the U.S., Europe, and other markets. We have been encouraged tosee a port facility and a municipal bus fleet that have been successfullyutilizing the fuel for approximately three years. Even with this technicalknowledge, we will need to continue to refine our efforts in this area as wellas attain the appropriate regulatory certification in order to bring on greaternumbers of customers and to better predict the cost and timing of work requiredto have fleets conform to the requirements of using our product.

 

**FirstQuarter Summary**

 

Operating results duringthe three months ended March 31, 2008 were mixed in comparison to thecomparable period ended March 31, 2007. Revenue declined significantly from$181,713 to $13,285 due in large part to the absence of additive shipments toour Asian distributor as well as the absence of sponsorship revenue reflectingreduced activity in CityHome projects. Cost of goods sold decreased by $123,155primarily reflecting reduced sales activity. Selling and marketing expenses forthe period ended March 31, 2008 were approximately $76,000 lower thanduring the comparable period ended March 31, 2007 as reduced U.S. expensesof approximately $130,000, attributable to lower advertising, consulting andCityHome costs, was offset by approximately $50,000 of higher consulting andconference expenses in our Spanish subsidiary. Product testing and governmentgrant (net) expenses in the quarter ended March 31, 2008 were approximately$129,000 lower than in the comparable period ended March 31, 2007 due tothe timing of research costs incurred. General and administrative expenses forthe quarter ended March 31, 2008 were approximately $720,000 lower thanfor the quarter ended March 31, 2007 primarily attributable toapproximately $915,000 in lower U.S. costs (including $335,000 lower personnelcosts related to staff reductions, $88,000 lower stock option compensationexpenses, $135,000 lower travel costs, and $253,000 of lower professional fees)offset by approximately $188,000 of increased travel and consulting costs inSpain and Ireland which were largely attributable to market development, theYellTec acquisition and fund-raising efforts with European investors. Costsrelated to the YellTec acquisition, amounting to approximately $35,000 for thethree months ended March 31, 2008, are expensed as incurred.

 

**CashRequirements and Liquidity**

 

To date, we have not hadany bank trade facilities, except an overdraft line in the U.K. used to meetoperating needs and a small vehicle loan, both of which have been paid andcanceled prior to 2007. However if the Company achieves significant sales, weplan to apply for trading lines with banks in the U.S. and Brazil as a means tofinance our working capital needs.

 

AMEX requires thatminimum 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 experiencedcontinuing losses for the past four years. In order to return to fullcompliance, O2Diesel needed to have stockholders’ equity of $6.0 millionby

 

9

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

June 2006 andmaintain this level going forward. In accordance with the procedures ofthe AMEX, we filed a plan (“Plan”) with it to demonstrate the steps we willtake to return to full compliance. On February 15, 2005, the AMEX notifiedus that it had accepted our Plan, and that we would be given until June 2006in which to regain compliance with the AMEX’s listing rules. To achieve thatlevel of stockholders’ equity, we anticipated having to raise a total ofapproximately $10.0 million in new equity during 2005. In December 2005,the Company determined that it could not meet certain conditions of the planand met with representatives of the AMEX to discuss the need to develop anamended 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 Companyclosed an offer to existing warrant holders to exercise their warrants at areduced price for proceeds of approximately $1.5 million (after expenses) andthree private placements totaling $7.5 million.

 

On July 17, 2006,the Company received a letter from the AMEX indicating that the Company hasregained compliance with AMEX listing requirements. The Company remained incompliance with the AMEX listing standards as of December 31, 2006.However, for the quarter ended March 31, 2007, the Company did not meetthe listing standards with regard to the need to have stockholders’ equity of$6.0 million. As more fully described above in the “Listing of Common Stock on AMEX” section, the Company has remainedout of compliance with this requirement. On April 21, 2008, the Companyreceived notice from AMEX indicating its determination to initiate delistingproceedings and on April 28, 2008, the Company announced that it begantrading on the Over the Counter Bulletin Board under the trading symbol OTOD.Based on our projected level of expenses and the cash on hand as shown on ourconsolidated balance sheet at March 31, 2008, we will need to raiseadditional funds in 2008 to allow us to execute our business plan.

 

As a result of the lack of a sales history for our products, we do nothave sufficient historical financial data for any periods on which toaccurately forecast future revenues or operating expenses in connection with achievingsuch revenues.  As such, we are not ableto project with certainty the additional funds that will need to beraised.  As stated previously, even withthe fund raising completed in 2006 and 2007, we will need to raise additionalequity during 2008.

 

The Company hasundertaken a number of efforts to address its short-term liquiditychallenges.  We have aggressively pursuednew funding initiatives with the YellTec and KL transactions.  We have engaged in renegotiations withEnergenics Holdings to complete this transaction.  The work under our government contracts hascontinued, which provides funds for Company projects with the military and ourefforts to obtain regulatory approvals. We continue to hold discussions with a number of potential investors andwork with a professional investor relations service company to assist withthese efforts.  In connection with ourefforts to attract new investments, there can be no assurance that we will besuccessful in doing so.  Nor can there beany assurance that the Company will generate sales and sponsorship feesfollowed by the collection of cash to offset our operating expenses.

 

As shown in theconsolidated statements of operations contained in this report, we havegenerated only $13,285 in sales, and had sponsorship income of $0 associatedwith the CityHomeTM programs, for the three months ended March 31, 2008. Asof the date of this report, we have only minimal orders on hand for eitherO2D05 or O2DieselTM, other than our supply requirements for Energenics  Lastly, there can be no assurance that actualevents will not differ from those anticipated, or that general economicconditions may not vary significantly in ways that could negatively impact ouroperations and cash position.

 

**Research &Development**

 

The Company has 82patents granted or applications pending for nine different proprietary fuel andadditive product inventions registered with the international WIPO (PCT)Registration System. Seven inventions currently have 43 patents granted, and 20applications pending in 22 different countries in Europe, North America, SouthAmerica and Asia. Two additional inventions currently have 19 patentapplications pending and about to undergo examination in 16 differentcountries. In August 2008, one of these inventions could be the subject offurther patent applications in several additional countries worldwide which aremembers of the Patent Cooperation Treaty. During this period, O2Diesel’sintellectual property rights over its additive products are protected throughits registration with the WIPO (PCT) Registration System and its pendingnational patent applications.

 

As part of ourcooperation agreement with our additive manufacturer (Cognis), we, along withCognis, are the joint owners of all patents covering both the use andcomposition of O2D05. All legal costs associated with preparing, filing andadministering the jointly owned patents are shared equally by the Company andCognis. We also have a number of patents that have been issued that relate tothe predecessor technology of O2D05. As a strategic measure, we continue tofund all costs necessary to maintain some of these patents. O2Diesel is thesole owner of these latter patents, which in general cover the use andcomposition of its prior generation technology.

 

We have registered atrademark in the U.S. and the European Union for a mark which includes thewords and numbers O2DieselTM as well as a figurative logo of thewords. We also registered trademarks for “CityHome” (and design) in eightclasses of goods and services, “TODAY’S CLEAN AIR SOLUTION TOMORROW’S BRIGHTERFUTURE” and “CITYHO2ME”, each covering one class of goods and services.

 

The Company has incurredsubstantial costs in carrying out tests to demonstrate that the use of ourproduct will enable customers to comply with environmental laws andregulations. As of March 31, 2008, we incurred expenses of $142,544 duringthe first quarter of  2008 in the U.S. inconnection with governmental sponsored projects and tests. Most of the costsincurred in these government test programs were reimbursed by appropriationsfrom the U.S. Departments of Energy and Defense.

 

10

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

At the end of the firstquarter of 2008, we have government test programs in progress with totalremaining costs to complete of approximately $1.02 million. Under theseprograms a wide array of engine tests and product demonstrations are to beconducted to further prove the emissions benefits of O2Diesel TM andto show that the fuel performs well in specific applications.

 

Included in the foregoingprograms is a product demonstration in Nevada to test a new fuel blend referredto as “O28”, which contains the Company’s proprietary additive, ethanol (8%),biodiesel (20%) and regular diesel fuel in non-tactical military equipment.Other programs underway include completing the protocols, emissions testverification and multimedia assessment to allow O2Diesel TM to beclassified as a Diesel Emissions Control Strategy fuel by the California AirResources Board.  O2Diesel is conductingdemonstrations with a number of school bus and transit agencies which areevaluating the performance of O2DieselTM as well as O2Diesel TMblended with B20 (diesel fuel blended with a 20% biodiesel component) for avariety of weather conditions, engine types, and operations. Related testingincluded using O2Diesel TM in large mining equipment as well asoffering the military a clean burning diesel fuel for non combat vehicles thatwould satisfy Energy Policy Act and Presidential Executive Orders requirementsfor reducing foreign oil dependence.  O2Diesel is currently working withthe military to obtain a procurement specification for purchasing the fuel. Overthe past two years, we initiated projects to develop the emissions test datanecessary to register these fuels for on road application with the EPA. Based on the government funding in place, we believe that approximately80% of the costs to conduct these tests may be funded by appropriations fromthe U.S. Departments of Energy and Defense.

 

We are investing time andeffort in the design and development of flame arrestor technology. This work ismore labor intensive rather than capital intensive.  However, it is a keystep in providing a turnkey solution to using these clean burning fuel options.Most of the design work has been performed by our own personnel and consultantswith the actual fabrication work contracted out to specialized manufacturers. Thiswork will continue in 2008.

 

In the firstquarter of 2008, we did not conduct additional research and developmentprojects in Brazil. However, we continued a fleet demonstration in Curitiba asa further effort to obtain approvals for O2Diesel TM  from theagencies that are responsible for the country’s petroleum industry andenvironmental laws.

 

These approvalsare administered and granted by two Brazilian agencies—ANP and IBAMA. ANP isthe National Fuel Regulation Agency and IBAMA is the National EnvironmentProtection Agency. Approvals are needed from both agencies before O2Diesel TM may be sold in Brazil. In 2004, we submitted applications to both agencies andreceived limited, but favorable approvals from each. ANP has classifiedO2Diesel TM  as an alternative diesel fuel. In addition, IBAMA,approved O2Diesel TM  for off road (e.g. in mining) andrailroad applications. Also, in response to requests that we submitted to ANP,it granted approval for O2Diesel TM  to be sold to specificcustomers and for specific regions in Brazil. In 2005, O2Diesel fuel receivedapprovals from the environmental and health secretaries of the cities of Rio deJaneiro, Curitiba and Maringá.

 

O2Diesel fuel hasalso become the first alternative fuel to be certified by the TECPAR’s nationalcertification program Transporte Limpo (Clean Transport). For 2008, we do notanticipate spending significant funds on various product and vehicle tests inBrazil.

 

Similar to ourefforts in Brazil, the Company also completed a demonstration for a municipalbus fleet in Anunción, Paraguay.

 

**Employees**

 

As of May 15, 2008,O2Diesel had twelve full-time employees, eleven of which are in the U.S. andone is in Europe. We had two temporary employees to support generaladministration. Currently, we rely on consultants to assist in commercializingour technology and to help us in key technical areas. At present, we employseven consultants in the U.S.; three in marketing and business development; onelaboratory technician, one chemist; and two in regulatory affairs. The Companyhas entered into separate consulting contracts with two shareholders of itsBrazilian subsidiary for the purpose of providing office rent andadministrative services and in lieu of employment contracts with these two individuals.In Europe, we employ two consultants, one for general management and businessdevelopment and one for regulatory affairs.

 

We will add new personnelin 2008 based on the pace of our commercialization. Under our business plan, wedo not see the need to add employees in the U.S. or Brazil, but we do plan toadd technical positions for our European market testing and development in2008. We anticipate continuing to employ a total of eleven consultants servingin most of the same capacities in 2008.

 

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

None.

 

11

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

**ITEM4. CONTROLS AND PROCEDURES.**

 

EVALUATION OF DISCLOSURECONTROLS AND PROCEDURES. O2Diesel’s Chief Executive Officer and Chief FinancialOfficer have evaluated the effectiveness of O2Diesel’s disclosure controls andprocedures (as such term is defined in Rules13a-15 and 15d-15 under theSecurities Exchange Act of 1934, as amended) as of the end of the periodcovered by this quarterly report (the “Evaluation Date”). Based on suchevaluation, such officers have concluded that, as of the Evaluation Date,O2Diesel’s disclosure controls and procedures are effective.

 

CHANGES IN INTERNALCONTROLS OVER FINANCIAL REPORTING. During the most recent fiscal quarter, therehave not been any changes in the Company’s internal controls over financialreporting or in other factors that have materially affected, or are reasonablylikely to materially affect internal controls over financial reporting.

 

**PART II.OTHER INFORMATION**

 

**ITEM1. LEGAL PROCEEDINGS.**

 

None.

 

**ITEM1A. RISK FACTORS**

 

Notapplicable to smaller reporting companies.

 

**ITEM2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

**KL Process Transaction**

 

On March 11, 2008,the Company’s wholly owned subsidiary, O2Diesel Europe, Plc (“O2Diesel Europe”)entered into an exclusive Technology License and Services Agreement (the “KLAgreement”) with KL Process Design Group, LLC (“KL”) whereby O2Diesel Europeobtained an exclusive license to use, exploit and sublicense certain KLintellectual property, know-how and processes for the production and sale ofethanol from feedstocks other than simple sugars and starches (the “KL Product”).  KL granted this license to O2Diesel Europe onan exclusive basis in Europe, India, Russia and other rapidly developing globalmarkets.  Pursuant to the Agreement, KLalso agreed to provide certain services related to the design and constructionof production plants necessary to produce the Product.

 

As part of the KLAgreement, the Company agreed to issue 1,000,000 shares of the Company’s commonstock to KL as consideration for the license, as well as certain royalty anddesign services fees.  The common stockwill be issued to the accredited investor in a transaction that will be exemptfrom registration pursuant to Section 4(2) of the Securities Actand/or Regulation D promulgated under the Securities Act.

 

**SUBSEQUENTCHANGES IN SECURITIES**

 

None.

 

**ITEM3. DEFAULTS UPON SENIOR SECURITIES.**

 

None.

 

**ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

None

 

**ITEM5. OTHER INFORMATION.**

 

None

 

12

 

**O2DieselCorporation**

**(ADevelopment Stage Company)**

**March 31,2008**

 

**ITEM6. EXHIBITS.**

     Thefollowing exhibits are filed herewith.

 
| ** ** | ** ** | **Description**                                                                                                                                                                                    |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1       |       | Letter Agreement,  effective as of January 2, 2008, by and between O2Diesel Corporation and  ProEco Energy Company (1)                                                                        |
|       |       |                                                                                                                                                                                               |
| 10.2       |       | Letter Agreement, effective  as of February 2, 2008, by and between O2Diesel Corporation and ProEco  Energy Company (1)                                                                       |
|       |       |                                                                                                                                                                                               |
| 10.3       |       | Letter Agreement  effective as of March 19, 2008, by and between O2Diesel Corporation and  ProEco Energy Company (2)                                                                          |
|       |       |                                                                                                                                                                                               |
| 10.4       |       | Technology License and  Services Agreement, effective as of March 11, 2008, by and between  O2Diesel Corporation and KL Process Design Group, LLC +(3)                                        |
|       |       |                                                                                                                                                                                               |
| 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 (3)         |
|       |       |                                                                                                                                                                                               |
| 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 (3)         |
|       |       |                                                                                                                                                                                               |
| 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 (3) |

 
| (1)    |   | Previously filed as an  exhibit to the Company’s annual report on Form 10-KSB on March 31,  2008, and incorporated herein by reference. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                   |
| (2)    |   | Previously filed as an  exhibit to the Company’s quarterly report on Form 8-K on March 21,  2008 and incorporated herein by reference.  |
|   |   |                                                                                                                                                   |
| (3)    |   | Filed herewith.                                                                                                                                        |

 
| + |   | Certain confidential  material contained in the document has been omitted and filed separately with  the Securities and Exchange Commission pursuant to Rule 406 of the  Securities Act of 1933, as amended or Rule 24b-2 of the Securities and  Exchange Act of 1934, as amended. |
|---|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**12. SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedhereunto duly authorized.

 
|                     |                                |                                                     |
|--------------------------|-------------------------------------|----------------------------------------------------------|
|                     | O2DIESEL  CORPORATION  (Registrant) |                                                     |
|                     |                                |                                                     |
| Date: May 15,  2008 | By:                                 | /s/ Alan Rae                                             |
|                     |                                | Alan Rae                                                 |
|                     |                                | Chief Executive  Officer   (Principal Executive Officer) |
|                          |                                     |                                                          |  |

 
| Date: May 15, 2008 | By:    | /s/ David H. Shipman                                                    |
|-------------------------|--------|-------------------------------------------------------------------------|
|                    |   | David H. Shipman                                                        |
|                    |   | Chief Financial Officer    (Principal Financial and Accounting Officer) |
|                    |   |                                                                    |

 

13