**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**





**WASHINGTON,
      DC 20549**





**FORM
      10-QSB**




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


**FOR
      THE QUARTERLY PERIOD ENDED June 30, 2006**




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


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





**Commission
      File Number: 001-32228**





**O2DIESEL
      CORPORATION**


(Name
      of
      small business issuer in its charter)




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




100
      COMMERCE DRIVE, Suite 301


NEWARK,
      DELAWARE 19713


(Address
      of Principal Executive Offices)





(302) 266-6000


(Issuer’s
      telephone number)





Not
      Applicable


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





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


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


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


Yes þ No o





APPLICABLE
      ONLY TO CORPORATE ISSUERS





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


Yes o No þ





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





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


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


Yes o No o





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


equity,
      as of the latest practicable date:





As
      of
      August 1, 2006, the registrant had 73,753,272 shares of Common
      Stock,


$0.0001
      par value per share, issued and outstanding





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










O2DIESEL
      CORPORATION


FOR
      THE
      QUARTER ENDED June 30, 2006


INDEX
      TO
      FORM 10-QSB





PART
      I
      FINANCIAL INFORMATION




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




NOTE
      REGARDING FORWARD LOOKING STATEMENTS





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





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











O2Diesel
      Corporation


(A
      Development Stage Company)





FINANCIAL
      INFORMATION


ITEM
      1.




**Consolidated
        Balance Sheet**


**June
        30, 2006**
  **ASSETS****CURRENT
                  ASSETS**Cash
              
              $
              5,541,560Restricted
                  cash
              
              
              3,829,903Accounts
                  receivable
              
              
              6,750Due
                  from related parties
              
              
              45,788Other
                  receivables
              
              
              402,890Unbilled
                  appropriations receivable
              
              
              221,405Inventory
              
              
              160,403Prepaid
                  expenses, parts and deposits
              
              
              227,365Total
                  current assets
              
              
              10,436,064**FURNITURE
                  AND EQUIPMENT**Office
                  furniture equipment
              
              
              200,886Fuel
                  and test equipment
              
              
              184,056384,942Less
                  accumulated depreciation
              
              
              (171,555
              )213,387**TOTAL
                  ASSETS**
              
              ***$***
              ***10,649,451*****LIABILITIES
                  AND STOCKHOLDERS' EQUITY****CURRENT
                  LIABILITIES**Accounts
                  payable
              
              $
              854,445Accrued
                  expenses
              
              
              250,693Due
                  to related parties
              
              
              183,415Deferred
                  grants
              
              
              651,530Deferred
                  marketing program
              
              
              273,333Other
                  current liabilities
              
              
              1,573Total
                  current liabilities
              
              
              2,214,989**TOTAL
                  LIABILITIES**
              
              
              **2,214,989****STOCKHOLDERS'
                  EQUITY**Preferred
                  stock: par value of $0.0001; 20,000,000 shares authorized;none
                  issued and outstanding
              
              
              –Common
                  stock: par value of $0.0001; 100,000,000 shares
                  authorized;73,734,522
                  issued and outstanding
              
              
              7,373Additional
                  paid-in capital
              
              
              37,604,693Unearned
                  compensation
              
              
              (200,408
              )Accumulated
                  other comprehensive income
              
              
              4,481Deficit
                  accumulated during the development stage
              
              
              (28,981,677
              )Total
                  stockholders' equity
              
              
              8,434,462**TOTAL
                  LIABILITIES AND STOCKHOLDERS' EQUITY**
              
              ***$***
              ***10,649,451***





See
      Notes
      to Financial Statements




F-1




**02Diesel
        Corporation**


**(A
        Development Stage Company)**
 **Consolidated
        Statements of Operations**
  October
                  14, 2000(inception)Six
                  months ended June 30,
              
              Three
                  months ended June 30,
              
              through2006
              
              2005
              
              2006
              
              2005
              
              June
                  30, 2006**Revenue**Additive
                  Related Sales
              
              $
              68,500
              
              $
              44,064
              
              $
              30,375
              
              $
              28,820
              
              $
              339,760Sponsorship
                  Income
              
              
              36,996
              
              
              13,972
              
              
              24,249
              
              
              13,972
              
              
              100,998105,496
              
              
              58,036
              
              
              54,624
              
              
              42,792
              
              
              440,758**Expenses:**Cost
                  of goods sold
              
              
              54,342
              
              
              36,095
              
              
              26,257
              
              
              26,594
              
              
              261,282Selling
                  and marketing
              
              
              561,328
              
              
              802,294
              
              
              316,478
              
              
              368,084
              
              
              7,190,451Product
                  testing and government grants, net
              
              
              159,775
              
              
              291,831
              
              
              122,438
              
              
              131,107
              
              
              1,532,540General
                  and administrative
              
              
              3,147,711
              
              
              2,226,809
              
              
              1,621,498
              
              
              1,132,893
              
              
              21,280,062**Total
                  operating expense**
              
              
              3,923,156
              
              
              3,357,029
              
              
              2,086,671
              
              
              1,658,678
              
              
              30,264,335**Operating
                  loss**
              
              
              **(3,817,660**
              **)**
              
              **(3,298,993**
              **)**
              
              **(2,032,047**
              **)**
              
              **(1,615,886**
              **)**
              
              **(29,823,577**
              **)****Other
                  income (expense):**Interest
                  expense
              
              
              (4,092
              )
              
              (13,387
              )
              
              (2,447
              )
              
              (7,089
              )
              
              (118,392
              )Interest
                  income
              
              
              41,431
              
              
              3,348
              
              
              38,254
              
              
              410
              
              
              110,254Foreign
                  currency gain, net
              
              
              280,457
              
              
              -
              
              
              210,865
              
              
              -
              
              
              384,136Other
                  (expense)/income, net
              
              
              (3,528
              )
              
              917
              
              
              (231
              )
              
              1,371
              
              
              320,260**Total
                  other income (expense)**
              
              
              314,268
              
              
              (9,122
              )
              
              246,441
              
              
              (5,308
              )
              
              696,258**Loss
                  before provision (benefit) for income taxes**
              
              
              (3,503,392
              )
              
              (3,308,115
              )
              
              (1,785,606
              )
              
              (1,621,194
              )
              
              (29,127,319
              )Benefit
                  for income taxes
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              145,642**Net
                  loss**
              
              
              **(3,503,392**
              **)**
              
              **(3,308,115**
              **)**
              
              **(1,785,606**
              **)**
              
              **(1,621,194**
              **)**
              
              **(28,981,677**
              **)****Deemed
                  dividend to preferred shareholders**
              
              
              **(5,581,133**
              **)**
              
              **-**
              
              
              **(2,255,934**
              **)**
              
              **-**
              
              
              **(6,200,005**
              **)****Net
                  loss allocable to common stockholders**
              
              **$**
              **(9,084,525**
              **)**
              **$**
              **(3,308,115**
              **)**
              **$**
              **(4,041,540**
              **)**
              **$**
              **(1,621,194**
              **)**
              **$**
              **(35,181,682**
              **)**Net
                  loss per common share(basic
                  and diluted)
              
              $
              (0.16
              )
              $
              (0.11
              )
              $
              (0.06
              )
              $
              (0.05
              )
              $
              (1.10
              )Weighted
                  average shares of commonshares
                  outstanding
              
              
              57,335,896
              
              
              29,546,570
              
              
              67,759,855
              
              
              29,546,570
              
              
              54,919,107Recapitalization
                  resulting from the AAETechnologies
                  International PLC acquisition
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              23,071,019Weighted
                  average shares of commonshares
                  outstanding - giving effect to therecapitalization
              
              
              57,335,896
              
              
              29,546,570
              
              
              67,759,855
              
              
              29,546,570
              
              
              31,848,088




See
      Notes
      to Financial Statements





F-2





O2Diesel
      Corporation


(A
      Development Stage Company)


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


**October 14,
      2000 (Inception) through June 30, 2006**





Common
            
            AdditionalPreferred
                Stock
            
            Common
                Stock
            
            Unearned
            
            Stock
            
            Paid
                - InShares
            
            Amount
            
            Shares
            
            Amount
            
            Compensation
            
            Subscribed
            
            CapitalBalance
                at October 14, 2000 (Inception)Common
                stock issued in exchange for interest in wholly owned
                subsidiaries
            
            
            -
            
            $
            -
            
            
            43,008,772
            
            $
            430,088
            
            $
            -
            
            $
            -
            
            $
            3,603,415Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Common
                stock issued on various dates during 2001
            
            
            -
            
            
            -
            
            
            24,181,038
            
            
            241,810
            
            
            -
            
            
            -
            
            
            1,268,031Balance
                at December 31, 2001
            
            
            -
            
            
            -
            
            
            67,189,810
            
            
            671,898
            
            
            -
            
            
            -
            
            
            4,871,446Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Common
                stock issued at $0.225 per share on various dates during
                2002
            
            
            -
            
            
            -
            
            
            703,282
            
            
            7,033
            
            
            -
            
            
            -
            
            
            515,657Balance
                at December 31, 2002
            
            
            -
            
            
            -
            
            
            67,893,092
            
            
            678,931
            
            
            -
            
            
            -
            
            
            5,387,103Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Common
                stock issued on various dates during 2003
            
            
            -
            
            
            -
            
            
            555,556
            
            
            5,556
            
            
            -
            
            
            -
            
            
            119,444Common
                stock issued for consulting services
            
            
            -
            
            
            -
            
            
            200,000
            
            
            2,000
            
            
            -
            
            
            -
            
            
            43,000Common
                stock issued for remaining interest in subsidiaries on July 15,
                2003
            
            
            -
            
            
            -
            
            
            4,356,200
            
            
            43,562
            
            
            -
            
            
            -
            
            
            46,323Common
                stock issued upon exercise of stock options on various dates during
                2003
            
            
            -
            
            
            -
            
            
            8,670,881
            
            
            86,709
            
            
            -
            
            
            -
            
            
            1,131,595Recapitalization
                resulting from AAE acquisition on July 15, 2003
            
            
            -
            
            
            -
            
            
            (56,928,690
            )
            
            (814,283
            )
            
            -
            
            
            -
            
            
            814,283Common
                stock issued at $1.50 per share on various dates during
                2003
            
            
            -
            
            
            -
            
            
            3,333,333
            
            
            333
            
            
            -
            
            
            -
            
            
            4,999,667Expenses
                related to 2003 issuance of common stock and
                recapitalization
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (795,650
            )Subscriptions
                for 754,900 shares of common stock at $1.50 per share on various
                dates
                during 2003
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,132,350
            
            
            -Balance
                at December 31, 2003
            
            
            -
            
            
            -
            
            
            28,080,372
            
            
            2,808
            
            
            -
            
            
            1,132,350
            
            
            11,745,765Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Common
                stock issued at $1.50 per share on various dates in 2004
            
            
            -
            
            
            -
            
            
            1,070,451
            
            
            107
            
            
            -
            
            
            (1,132,350
            )
            
            1,535,770Preferred
                stock issued on various dates during 2004
            
            
            1,550,000
            
            
            155
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            5,478,609Balance
                at December 31, 2004
            
            
            1,550,000
            
            
            155
            
            
            29,150,823
            
            
            2,915
            
            
            -
            
            
            -
            
            
            18,760,144Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Common
                stock issued for consulting services
            
            
            -
            
            
            -
            
            
            63,750
            
            
            6
            
            
            -
            
            
            -
            
            
            63,094Warrants
                issued for consulting services
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            135,000Common
                stock issued at $0.70 per share on various dates in 2005
            
            
            -
            
            
            -
            
            
            7,515,981
            
            
            752
            
            
            -
            
            
            -
            
            
            4,832,439Common
                stock issued at $0.7125 per share on various dates in 2005
            
            
            -
            
            
            -
            
            
            3,228,070
            
            
            322
            
            
            -
            
            
            -
            
            
            2,090,178Common
                stock issued at $0.564 per share on various dates in 2005
            
            
            -
            
            
            -
            
            
            6,419,840
            
            
            642
            
            
            -
            
            
            -
            
            
            3,599,658Balance
                at December 31, 2005
            
            
            1,550,000
            
            
            155
            
            
            46,378,464
            
            
            4,637
            
            
            -
            
            
            -
            
            
            29,480,513Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Common
                stock issued via exercise of warrants on various dates in
                2006
            
            
            -
            
            
            -
            
            
            3,151,892
            
            
            315
            
            
            -
            
            
            -
            
            
            1,457,829Common
                stock issued for consulting services
            
            
            -
            
            
            -
            
            
            37,500
            
            
            4
            
            
            -
            
            
            -
            
            
            35,433Conversion
                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 the second quarter of
                2006
            
            
            -
            
            
            -
            
            
            8,666,666
            
            
            867
            
            
            -
            
            
            -
            
            
            6,256,282Fair
                value of unvested stock options upon adoption of SFAS 123
                R
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (376,031
            )
            
            -
            
            
            376,031Amortization
                of unearned compensation
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            175,623
            
            
            -
            
            
            -Balance
                at June 30, 2006
            
            
            -
            
            $
            -
            
            
            73,734,522
            
            $
            7,373
            
            $
            (200,408
            )
            
            -
            
            $
            37,604,693




See
      Notes
      to Financial Statements





F-3




O2Diesel
      Corporation


(A
      Development Stage Company)


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


**October 14,
      2000 (Inception) through June 30, 2006**


DeficitCommon
              
              Accumulated
              
              Accumulated
              
              TotalStock
              
              Other
              
              During
                  the
              
              Stockholders'Subscriptions
              
              Comprehensive
              
              Development
              
              EquityReceivable
              
              Income
                  (Loss)
              
              Stage
              
              (Deficit)Balance
                  at October 14, 2000 (Inception)Common
                  stock issued in exchange for interest in wholly owned
                  subsidiaries
              
              $
              -
              
              $
              -
              
              $
              (4,138,684
              )
              $
              (105,181
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              (1,406,709
              )
              
              (1,406,709
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (4,476
              )
              
              -
              
              
              (4,476
              )Comprehensive
                  Loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,411,185
              )Common
                  stock issued on various dates during 2001
              
              
              -
              
              
              -
              
              
              -
              
              
              1,509,841Balance
                  at December 31, 2001
              
              
              -
              
              
              (4,476
              )
              
              (5,545,393
              )
              
              (6,525
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              (1,712,803
              )
              
              (1,712,803
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (74,085
              )
              
              -
              
              
              (74,085
              )Comprehensive
                  loss:
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,786,888
              )Common
                  stock issued at $0.225 per share on various dates during
                  2002
              
              
              -
              
              
              -
              
              
              -
              
              
              522,690Balance
                  at December 31, 2002
              
              
              -
              
              
              (78,561
              )
              
              (7,258,196
              )
              
              (1,270,723
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              (4,230,296
              )
              
              (4,230,296
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              179,689
              
              
              -
              
              
              179,689Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (4,050,607
              )Common
                  stock issued on various dates during 2003
              
              
              -
              
              
              -
              
              
              -
              
              
              125,000Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              45,000Common
                  stock issued for remaining interest in subsidiaries on July 15,
                  2003
              
              
              -
              
              
              -
              
              
              (409,614
              )
              
              (319,729
              )Common
                  stock issued upon exercise of stock options on various dates during
                  2003
              
              
              -
              
              
              -
              
              
              -
              
              
              1,218,304-Recapitalization
                  resulting from AAE acquisition on July 15, 2003
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued at $1.50 per share on various dates during
                  2003
              
              
              -
              
              
              -
              
              
              -
              
              
              5,000,000Expenses
                  related to 2003 issuance of common stock and
                  recapitalization
              
              
              -
              
              
              -
              
              
              -
              
              
              (795,650
              )Subscriptions
                  for 754,900 shares of common stock at $1.50 per share on various
                  dates
                  during 2003
              
              
              (180,000
              )
              
              -
              
              
              -
              
              
              952,350Balance
                  at December 31, 2003
              
              
              (180,000
              )
              
              101,128
              
              
              (11,898,106
              )
              
              903,945Net
                  loss
              
              
              -
              
              
              -
              
              
              (6,728,014
              )
              
              (6,728,014
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (97,446
              )
              
              -
              
              
              (97,446
              )Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (6,825,460
              )Common
                  stock issued at $1.50 per share on various dates in 2004
              
              
              180,000
              
              
              -
              
              
              -
              
              
              583,527Preferred
                  stock issued on various dates during 2004
              
              
              -
              
              
              -
              
              
              -
              
              
              5,478,764Balance
                  at December 31, 2004
              
              
              -
              
              
              3,682
              
              
              (18,626,120
              )
              
              140,776Net
                  loss
              
              
              -
              
              
              -
              
              
              (6,852,165
              )
              
              (6,852,165
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              2,329
              
              
              -
              
              
              2,329Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (6,849,836
              )Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              63,100Warrants
                  issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              135,000Common
                  stock issued at $0.70 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              4,833,191Common
                  stock issued at $0.7125 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              2,090,500Common
                  stock issued at $0.564 per share on various dates in 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              3,600,300Balance
                  at December 31, 2005
              
              
              -
              
              
              6,011
              
              
              (25,478,285
              )
              
              4,013,031Net
                  Loss
              
              
              -
              
              
              -
              
              
              (3,503,392
              )
              
              (3,503,392
              )Foreign
                  currency translation adjustment
              
              
              -
              
              
              (1,530
              )
              
              -
              
              
              (1,530
              )Comprehensive
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              (3,504,922
              )Common
                  stock issued via exercise of warrants on various dates in
                  2006
              
              
              -
              
              
              -
              
              
              -
              
              
              1,458,144Common
                  stock issued for consulting services
              
              
              -
              
              
              -
              
              
              -
              
              
              35,437Conversion
                  of preferred stock into common stock on various dates in
                  2006
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock issued at $0.75 per share in the second quarter of
                  2006
              
              
              -
              
              
              -
              
              
              -
              
              
              6,257,149Fair
                  value of unvested stock options upon adoption of SFAS 123
                  R
              
              
              -
              
              
              -
              
              
              -
              
              
              -Amortization
                  of unearned compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              175,623Balance
                  at June 30, 2006
              
              $
              -
              
              $
              4,481
              
              $
              (28,981,677
              )
              $
              8,434,462





See
      Notes
      to Financial Statements





F-4





O2Diesel
      Corporation


(A
      Development Stage Company)


**Consolidated
      Statements of Cash Flows**


October
                  14, 2000Six
                  Months Ended June 30,
              
              (inception)
                  through2006
              
              2005
              
              June
                  30, 2006**Cash
                  flows from operating activites****Net
                  loss**
              
              **$**
              **(3,503,392**
              **)**
              **$**
              **(3,308,115**
              **)**
              **$**
              **(28,981,677**
              **)**Adjustments
                  to reconcile loss to net cash used in operating activites:Depreciation
              
              
              41,696
              
              
              33,083
              
              
              238,333Amortization
              
              
              -
              
              
              -
              
              
              7,786Write
                  off of patent
              
              
              -
              
              
              -
              
              
              337,329Write
                  off of obsolete inventory
              
              
              -
              
              
              -
              
              
              5,925Loss(Gain)
                  on sale/disposal of furniture & equipment
              
              
              7,364
              
              
              -
              
              
              (2,152
              )Non
                  cash contributions
              
              
              1,564
              
              
              -
              
              
              1,564Common
                  stock and warrants issued for consulting services
              
              
              35,437
              
              
              -
              
              
              238,537Amortization
                  of unearned compensation
              
              
              175,623
              
              
              -
              
              
              175,623Changes
                  in operating assets and liabilites:Accounts
                  receivable
              
              
              6,750
              
              
              860
              
              
              (6,750
              )Due
                  from/(to) related parties
              
              
              18,902
              
              
              79,417
              
              
              137,627Other
                  receivables
              
              
              (283,589
              )
              
              (134,298
              )
              
              (402,890
              )Inventory,
                  prepaid expenses and other current assets
              
              
              (209,569
              )
              
              (49,389
              )
              
              (615,098
              )Accounts
                  payable
              
              
              250,121
              
              
              3,533
              
              
              854,445Accrued
                  expenses
              
              
              (11,780
              )
              
              175,521
              
              
              250,693Deferred
                  grants
              
              
              355,434
              
              
              152,067
              
              
              651,530Deferred
                  marketing program
              
              
              (133,700
              )
              
              -
              
              
              273,333Other
                  current liabilities
              
              
              1,573
              
              
              (87,612
              )
              
              (9,585
              )**Cash
                  flows used in operating activities**
              
              
              **(3,247,566**
              **)**
              
              **(3,134,933**
              **)**
              
              **(26,845,427**
              **)****Cash
                  flows from investing activities**Restricted
                  cash
              
              
              (276,743
              )
              
              -
              
              
              (3,829,903
              )Purchase
                  of furniture and equipment
              
              
              (60,774
              )
              
              (5,759
              )
              
              (451,903
              )Proceeds
                  from sale of furniture & equipment
              
              
              600
              
              
              -
              
              
              12,500Purchase
                  of patent
              
              
              -
              
              
              -
              
              
              (345,115
              )**Cash
                  flows used in investing activities**
              
              
              **(336,917**
              **)**
              
              **(5,759**
              **)**
              
              **(4,614,421**
              **)****Cash
                  flows from financing activities**Net
                  proceeds from issuance of preferred stock
              
              
              -
              
              
              -
              
              
              5,478,764Net
                  proceeds from private placement
              
              
              -
              
              
              3,037,730
              
              
              5,953,757Net
                  proceeds from issuance of common stock
              
              
              7,715,293
              
              
              1,796,028
              
              
              25,570,988(Repayments)
                  / borrowings of bank debt
              
              
              -
              
              
              (5,883
              )
              
              -**Cash
                  flows provided by financing activities**
              
              
              **7,715,293**
              
              
              **4,827,875**
              
              
              **37,003,509**Effect
                  of exchange rate changes on cash
              
              
              (2,101
              )
              
              496
              
              
              (2,101
              )**Net
                  increase in cash**
              
              
              **4,128,709**
              
              
              **1,687,679**
              
              
              **5,541,560****Cash
                  at beginning of period**
              
              
              **1,412,851**
              
              
              **1,172,250**
              
              
              **-****Cash
                  at end of period**
              
              **$**
              **5,541,560**
              
              **$**
              **2,859,929**
              
              **$**
              **5,541,560**Cash
                  paid for interest
              
              $
              4,092
              
              $
              2,397
              
              $
              109,040Cash
                  paid for income taxes
              
              
              None
              
              
              None
              
              
              None





Non-cash
      transactions: Conversion of Bridge loan to common stock at 9/30/2003,
      $2,322,500.


Conversion
      of preferred stock to common stock at various dates during 2006, $1,550,000.





See
      Notes
      to Financial Statements





F-5





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





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





**The
      Company**





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





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





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





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





On
      June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
      an application to list 46,518,898 shares of our common stock under the symbol
      OTD. Subsequent to this date, the Exchange has approved additional applications
      to list 45,985,710 shares of the Company’s common stock so that the total number
      of shares approved for listing is now 92,504,608. Our shares began to trade
      on
      the Exchange on July 1, 2004.





**Basis
      of Presentation**





The
      Company’s unaudited consolidated financial statements for the three and six
      months ended June 30, 2006, have been prepared on a going concern basis, which
      contemplates the realization of assets and the settlement of liabilities and
      commitments in the normal course of business. At June 30, 2006, the Company
      had
      working capital of $8,221,075 and had accumulated losses of $28,981,677.
      Further, management received notice in December 2004 from the AMEX that the
      Company was not in compliance with the listing standards of the Exchange,
      because it lacked the requisite amount of stockholders’ equity. In accordance
      with the procedures of the Exchange, we filed a plan (“Plan”) with it to
      demonstrate the steps we would take to return to full compliance. On
      February 15, 2005, the AMEX notified us that it had accepted our Plan, and
      that we would be given until June 2006 in which to regain compliance with
      the Exchange’s listing rules. To achieve that level of stockholder’s equity, we
      anticipated having to raise a total of approximately $10.0 million in new
      equity during 2005. In December 2005, the Company determined that it could
      not meet certain conditions of the Plan and met with representatives of the
      AMEX
      to discuss the need to develop an amended plan to demonstrate how the Company
      will be in compliance by June 2006.





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





As
      described under the “Warrants” section, the Company closed an offer to existing
      warrant holders to exercise their warrants at a reduced price for proceeds
      of
      $592,692 (after expenses) as part of its efforts to meet these requirements. Subsequent
      to this closing, several other existing warrant holders elected to exercise
      their warrants at the contract price identified in their warrant documentation.
      Proceeds for these exercises were $865,452 (after expenses).





As
      described under the “$4.0 and $2.5 Million Private Placements” section, the
      Company closed two private placements on April 27, 2006 totaling $6.5 million
      as
      part of the effort to comply with the AMEX requirement. The Company received
      $6,257,149 (after expenses) from these Private Placements and it issued
      8,666,666 shares of its common stock.





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





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





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company has regained compliance with AMEX listing requirements.





F-6




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





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





In
      January 2005, the Company retained a third party to raise, in a series of
      two private placements of the Company’s common stock, $5.0 million at a
      price of $0.70 per share. This offering price per share represented a discount
      from the market value of the Company’s common stock of approximately ten-percent
      (10%). The first private placement was for just under $2.0 million
      (“$2.0 million Private Placement”) and the second was for just over
      $3.0 million (“$3.0 million Private Placement”, and together with the
      $2.0 million Private Placement, the “Private Placements”). As part of these
      transactions, the Company was obligated to comply with certain conditions in
      connection with the $2.0 million Private Placement, and the Company was
      also obligated to satisfy still other conditions applicable to the
      $3.0 million Private Placement.





The
      AMEX
      requires that shareholder approval be obtained by the Company for the sale
      of
      common stock in a transaction if the price of the shares to be sold is less
      than
      the greater of book or market value, and the number of shares equal
      twenty-percent (20%) or more of the presently outstanding common stock. In
      order
      to comply with this requirement, the Company was required to obtain shareholder
      approval for the $3.0 million Private Placement. No shareholder approval
      was required for the shares issued in conjunction with the $2.0 million
      Private Placement.





Pursuant
      to the $2.0 million Private Placement, the Company received qualified
      subscriptions for 2,803,428 shares of its common stock and total proceeds of
      $1,962,400, before payment of an 8% commission and other expenses. The parties
      subscribing to these shares agreed to waive certain of the conditions to permit
      the transaction to be closed as to their respective subscriptions. An initial
      closing for the $2.0 million Private Placement was held on March 17,
      2005 for 1,915,143 shares. A final closing for the remaining 888,285 shares
      was
      held on May 20, 2005.





On
      June 10, 2005, an initial closing was held for the $3.0 million
      Private Placement covering 4,583,973 shares of common stock, for total proceeds
      of $3,208,781, before payment of an 8% commission and other expenses. In
      addition, the Company received additional subscriptions for 128,580 shares
      of
      its common stock and cash of $90,006, before payment of an 8% commission. As
      part of the terms for the $3.0 million Private Placement, the Company was
      required to satisfy two conditions in order to close the transaction. As
      indicated above, the first condition required that shareholder approval be
      obtained to issue the shares, and this was approved by the Company’s
      shareholders at its annual shareholder meeting held on May 31, 2005.
      Pursuant to the second condition, the Company was required to expand its senior
      management team, and it did so by creating the position of Chief Operating
      Officer and President. The Board of Directors (the “Board”) confirmed that both
      of these conditions had been satisfied as of May 31, 2005. On
      August 9, 2005, the Company received the final $89,874 (after expenses) for
      the $3.0 million Private Placement, and these transactions are now
      closed.





In
      total
      the Company received $4,833,191 (after expenses) from the Private Placements
      and
      it issued 7,515,981 shares of its common stock.





Subscribers
      to both of the Private Placements received one warrant to purchase one
      additional share of common stock for each two shares of common stock purchased.
      The warrant expires twenty-four months following the closing of the
      $2.0 million Private Placement and $3.0 million Private Placement,
      respectively. Each warrant is exercisable at a price of $0.70 per share during
      the first twelve months following the close of each Private Placement, or at
      an
      exercise price of $1.05 per share in the second twelve months following the
      close of each Private Placement. The total number of warrants issued was
      3,757,990.





**$2.3
      Million Private Placement**





On
      September 20, 2005, the Company entered into a Common Stock and Warrant
      Purchase Agreement (“$2.3 million Purchase Agreement”) with a European
      investor (the “Purchaser”) for 3,228,070 shares of common stock at a purchase
      price of $0.7125 per share in a private placement for total proceeds of
      $2,300,000 (the “$2.3 million Private Placement”). As a condition of
      enforceability of the $2.3 million Purchase Agreement against the Company,
      the Purchaser was required to fund the purchase price in an escrow account,
      which funds were received on September 28, 2005.





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





As
      part
      of the transaction, the Company has agreed to sell up to an additional $700,000
      of its common stock to the Purchaser at a purchase price of $0.7125 per share
      for 982,456 shares. This offer expired unexercised on March 20,
      2006.





The
      Company agreed to issue warrants to purchase 1,614,035 shares of common stock
      at
      an exercise price of $0.7125 per share to its advisor in connection with this
      transaction. The warrants expire forty-two months after the date of
      issuance.





F-7





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





The
      transaction closed and the warrants were issued on October 24, 2005 and the
      funds were released from the escrow account on October 26, 2005. In
      addition, in connection with this transaction, the Company entered into an
      investor relations contract that awarded 100,000 shares of restricted common
      stock which vests over a one year period ending September 20, 2006. As of
      June 30, 2006, the restrictions on 81,250 shares issued under this contract
      have
      lapsed and such shares were earned and able to be sold.





**$3.6
      Million Private Placement**





On
      October 28, 2005, the Company entered into an agreement with a European
      producer of bioethanol to provide funding and commercial support to develop
      the
      European market for the Company’s products. The parties entered into a Common
      Stock and Warrant Purchase Agreement for 6,419,840 shares of the Company’s
      common stock in a private placement, for total proceeds of 3,000,000€, or
      approximately $3.6 million USD at the then current exchange rates. The
      Company agreed to use these funds exclusively for the development of the
      European market (defined in the agreement as Spain, Germany, France, Portugal,
      Belgium, Netherlands and such other countries in the EU that the parties may
      agree to). The parties also entered into a Commercial Agreement, in which the
      investor and the Company will jointly develop the market for the Company’s
      products in Europe during a five year period. As part of the Commercial
      Agreement, the investor will be the exclusive supplier of the ethanol to be
      used
      in the blending of the Company’s product within the territory.





As
      part
      of the transaction, the Company issued warrants to purchase 2,853,262 shares
      of
      common stock at an exercise price of $0.85 per share during the period six
      to
      forty two months subsequent to the date of issuance or at an exercise price
      of
      $1.13 per share during the period forty three to sixty six months after the
      date
      of issuance. The warrants expire sixty six months after the date of issuance.
      The transaction closed and the funds were received on December 16,
      2005.





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





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





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





The
      purchase price of both transactions represented a discount of approximately
      10%
      in comparison to the prevailing market price of the Company’s Common Stock
      during the period of negotiations for these private placements.





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





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





**Warrants**





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





**2.
      Summary of Significant Accounting Policies**





**Principles
      of Consolidation**





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





**Cash
      and Cash Equivalents**





The
      Company considers all highly liquid instruments with a maturity of three months
      or less at the time of issuance to be cash equivalents. As of June 30, 2006,
      cash deposits exceeded federally insured limits which are generally $100,000
      per
      financial institution.





**Restricted
      Cash**





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





**Fair
      Value of Financial Instruments**





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





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





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





**Inventories**





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





F-8





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Furniture
      and Equipment and Depreciation**





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





Office
      furniture and equipment: 3 to 5 years


Fuel
      and
      test equipment: 5 years





Depreciation
      expense recorded in the accompanying Consolidated Statements of Operations
      was
      $16,973 and $33,083, respectively for the three and six months ended June 30,
      2005, and was $20,780, $41,696 and $238,333 respectively for the three and
      six
      months ended June 30, 2006 and for the period October 14, 2000
      (inception) through June 30, 2006.





**Accounting
      for Impairment of Long-Lived Assets**





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





**Financial
      Instruments**





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





**Revenue
      Recognition**





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





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





The
      Company has supported certain fleet equipment conversion costs in these
      CityHomeTM initiatives and has also been required to bear the incremental costs
      of the blended fuel, where it is experienced. Whenever the expected costs of
      the
      program are determined to be in excess of the contracted sponsorship fees and
      related fuel additive revenue, the Company records the loss for the contract
      as
      an expense and a deferred liability to be amortized over the life of the
      contract. As of June 30, 2006, costs remaining to be amortized for CityHomeTM
programs were recorded on the balance sheet as Deferred Marketing Program in
      the
      amount of $273,333. The Company recorded $49,501 and $208,263 in costs for
      the
      CityHomeTM initiatives in excess of sponsorship fees during the three and six
      months ended June 30, 2005 and $69,480, $88,753 and $958,727 of costs in excess
      of sponsorship fees for CityHomeTM initiatives for the three and six months ended
      June 30, 2006 and for the period October 14, 2000 (inception) through
      June 30, 2006, respectively.





**Shipping
      and Handling Costs**





The
      Company classifies costs associated with shipping and handling activities within
      cost of goods sold in the consolidated statements of operations. Shipping and
      handling costs were $3,048 and $5,015 for the three and six months ended June
      30, 2005 and were $4,766, $7,703 and $44,795 respectively for the three and
      six
      months June 30, 2006 and for the period October 14, 2000
      (inception) through June 30, 2006.





**Advertising
      Expenses**





Advertising
      costs are expensed as incurred. Advertising expense was $500,000 for the year
      ended December 31, 2003, and $450,000 for the period October 14, 2000
      (inception) to December 31, 2004. There were no advertising
      expenditures for the three and six months ended June 30, 2006, or in 2005,
      2004
      or prior to 2003. In 2004, the Company terminated the contract and recovered
      $50,000 of the expense.





**Research
      and Development Costs**





Research
      and development costs are expensed as incurred.





F-9





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**Product
      Test and Demonstration Appropriations**





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





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





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





**Accounting
      for Stock-Based Compensation**





Statement
      of Financial Accounting Standards (“SFAS”) No. 123, Accounting for
      Stock-Based Compensation (SFAS 123) previously provided companies with a choice
      to follow the provisions of SFAS 123 in determination of stock-based
      compensation expenses or to continue with the provisions of Accounting
      Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
      (APB 25). Under APB 25, if the exercise price of the stock options granted
      equals or exceeds the market price of the underlying common stock on the date
      of
      grant, no compensation expense is recognized.





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004),
“Share-Based Payment” (SFAS No. 123(R)), which replaces SFAS No. 123 and
      superseded APB Opinion No. 25. SFAS No. 123(R) requires all
      share-based payments to employees, including grants of employee stock options,
      to be recognized in the financial statements based on their fair values
      beginning with the first annual reporting period that begins after
      December 15, 2005, with early adoption encouraged. The pro forma
      disclosures previously permitted under SFAS No. 123 will no longer be an
      alternative to financial statement recognition.





Effective
      January 1, 2006, the Company adopted the fair value recognition provisions
      of SFAS No. 123(R), using the modified prospective transition method. As a
      result, the Company’s net loss before taxes is $75,267, $175,623, and $175,623
      respectively for the three and six months ended June 30, 2006 and for the period
      October 14, 2000 (inception) through June 30, 2006 higher than if it had
      continued to account for share-based compensation under Accounting Principles
      Board (“APB”) opinion No. 25.





Prior
      to
      January 1, 2006, the Company’s share-based employee compensation plan was
      accounted for under the recognition and measurement provisions of APB 25 and
      related Interpretations, as permitted by FASB Statement No. 123,
“Accounting for Stock -Based Compensation”, (SFAS 123). The Company did not
      recognize stock-based compensation cost in its statement of operations for
      periods prior to December 31, 2005 as all options granted had an exercise
      price equal to or higher than the market value of the underlying common stock
      on
      the date of grant. However, compensation expense was recognized under APB
      Opinion 25 for certain options granted to non-employees of the Company based
      upon the intrinsic value.





The
      Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
      which the Board of Directors has authorized 7,212,957 shares of common stock
      to
      be reserved for future issuance under the Plan. At December 31, 2005 the
      Company had committed to award 7,750,000 options to purchase common stock to
      certain officers, employees and directors, of which 5,950,000 options have
      been
      approved and granted by the Board of Directors. As of June 30, 2006, one
      employee who had been promised (but not granted) 600,000 options left the
      employment of the Company and forfeited the promised options. Four other
      employees received new promises for 350,000 options, resulting in net
      commitments from the Company of 7,500,000 options to purchase common stock.
      The
      Company expected to obtain approval from the shareholders during 2006 to
      increase the number of common shares available for issuance under the Incentive
      Plan in order to effectuate the grant of the remaining stock options promised
      to
      plan participants. This approval was obtained at the Company’s annual
      shareholder meeting on July 6, 2006.





Stock
      options generally vest over three years and will expire 10 years from the
      effective date. However, the Company has the latitude under the Incentive Plan
      to issue options at various stages of vesting. Once these options are granted
      by
      the Board under the provisions of the plan, the Company will record a
      compensation charge for the difference between the fair value of the common
      stock and the exercise price of the options on the date of issuance if the
      fair
      value of the common stock exceeds the exercise price of the option on that
      date.





F-10





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





Statement
      of Financial Accounting Standards No. 123 (“SFAS No. 123”) required
      pro forma information regarding net income and earnings per share as if the
      Company had accounted for its employee stock options under the fair value method
      of SFAS No. 123. The fair value of each option granted was estimated on the
      date of grant using the Black-Scholes option-pricing model. The assumptions
      used
      with this model for 2005 were an expected life of 3 years, a zero dividend
      yield, volatility ranging from 59% to 120% (depending on date of grant), and
      risk free interest rates ranging from 3.39% to 3.96% (depending on date of
      grant).





For
      purposes of pro forma disclosures, the estimated fair value of the options
      is to
      be amortized over the option’s vesting period. Had compensation costs been
      determined in 2004 and 2005 based on the fair value at the grant date for awards
      under this plan consistent with the method of SFAS No. 123, the impact on the
      Company’s financial results for the years ended December 31, 2004 and
      December 31, 2005 would have been to record additional compensation cost,
      thereby increasing net loss allocable to common stockholders by $137,500 in
      2004
      and $767,285 in 2005. This would have increased the loss per common share
      allocable to common stockholders for the year ended December 31, 2004 by $.01
      while for the year ended December 31, 2005 the effect would have been less
      than $.02 per common share. The following table displays the pro forma results
      of recognizing this compensation expense.




**Three
                Months**
            
            **Six
                Months****Ended**
            
            **Ended****June
                30, 2005**
            
            **June
                30, 2005**Net
                Loss Allocable to Common Shareholders
            
            $
            (1,621,194
            )
            $
            (3,308,115
            )Additional
                Compensation Expense
            
            $
            (230,186
            )
            $
            (537,100
            )Pro
                Forma Net Loss Allocable to Common Shareholders
            
            $
            (1,851,380
            )
            $
            (3,845,215
            )Pro
                Forma Net Loss Per Common Share (basic and diluted)
            
            $
            (0.06
            )
            $
            (0.13
            )




**Income
      Taxes**





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





**Use
      of Estimates**





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





**Foreign
      Subsidiaries**





The
      Company has foreign subsidiaries whose local currency has been determined to
      be
      the functional currency. For these foreign subsidiaries, the assets and
      liabilities have been translated using the current exchange rates, and the
      income and expenses have been translated using the weighted average of
      historical exchange rates during the reporting period. The adjustments resulting
      from translation have been recorded separately in shareholders’
(deficit) equity as “other comprehensive income (loss)” and are not
      included in determining the consolidated net loss. As of June 30, 2006,
      accumulated other comprehensive income included $4,481 of cumulative income
      from
      foreign currency translation.





The
      Company began operations in Brazil in March of 2004 by establishing a 75% owned
      subsidiary. Revenue recognized was $2,501 and $2,501for the three and six months
      ended June 30, 2005, and was zero for the three and six months ended June 30,
      2006, and $7,682 for the period October 14, 2000 (inception) through June 30,
      2006. As of June 30, 2006 the Brazilian subsidiary had net assets of $49,583.
      Transactions in Brazil are denominated in, and the functional currency is,
      the
      Brazilian Real. Accordingly, no currency exchange rate gains or losses are
      recorded in the accompanying consolidated statement of operations for Brazilian
      operations. At June 30, 2006, the Brazilian operations had aggregate losses
      of
      $1,490,537. The minority stockholder’s portion of aggregate losses is not
      recorded in the consolidated balance sheet since reimbursement of this amount
      from the minority stockholders is not assured.





F-11





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





In
      conjunction with the $3.6 million Private Placement, the Company maintained
      a deposit account of approximately 3,000,000€ in its Irish subsidiary. For the
      three and six months ended June 30, 2006, the Company recorded a foreign
      currency gain of $210,865 and $280,457 as a result of this holding.





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





**Segment
      Reporting**





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





**Impairment
      of Intellectual Property Rights**





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





**Interim
      Financial Statements**





The
      unaudited interim consolidated financial statements of the Company have been
      prepared in accordance with accounting principles generally accepted in the
      United States for interim financial information. In the opinion of management,
      all adjustments (consisting of normal recurring adjustments) considered
      necessary to present fairly the financial position of the Company as of June
      30,
      2006 and the results of operations and cash flows presented herein from
      inception (October 14, 2000) through June 30, 2006 have been included in
      the financial statements. Interim results are not necessarily indicative of
      results of operations that may be expected for the year ending December 31,
      2006. It is recommended that this financial information be read with the
      complete financial statements included in the Company’s Form 10-KSB dated
      December 31, 2005 previously filed with the Securities and Exchange
      Commission.





**3.
      Government Appropriations**





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





In
      2002,
      the Company received an appropriation of $1,107,734 from the U.S. Department
      of
      Energy (“DOE”) to test the Company’s fuel additive as well as its blended fuel,
      O2DieselTM. The appropriation was increased to $2,039,651 as of
      September 15, 2004. This appropriation is managed for the DOE by the
      National Renewable Energy Laboratory (“NREL”) under a contract which, as
      amended, continues until June 30, 2007. Under the terms of the contract,
      the Company is reimbursed by NREL for 80% of the costs incurred to complete
      the
      Statement of Work as set forth in the contract. The Company charges all expenses
      as incurred to operations and accrues all amounts receivable under the contract
      as a reduction to contract expenses when the Company is reasonably certain
      all
      conditions of the reimbursement are satisfied. As of June 30, 2006, the Company
      had incurred cumulative costs of $1,718,764 towards completion of the contract,
      leaving a balance of $320,887 in costs to complete the contract. From the
      inception of the contract in December 2002 through June 30, 2006, the
      Company billed NREL $1,329,200 of which $130,403 is included in other
      receivables as of June 30, 2006. In addition, the Company recorded $45,812
      of unbilled receivables at June 30, 2006 under this appropriation .





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





In
      2003,
      the Company received an appropriation of $1,123,834 to test the Company’s fuel
      additive under the California Air Resources Board (CARB) Diesel Emissions
      Control Strategy (DECS) verification rules. The Company is eligible to
      receive reimbursements of 80% of costs incurred under a contract up to the
      appropriation amount, or $899,067. This appropriation is managed for the DOE
      by
      NREL, the National Renewable Energy Laboratory, which is expected to execute
      a
      contract with the Company in the third quarter of 2006. NREL authorized the
      Company to incur up to $100,000 toward contract activities beginning on
      December 15, 2005. No expenses were incurred under this contract during
      2005 and $164,871 of expenses were incurred during the six months ended June
      30,
      2006. Since the company does not have a signed contract and therefore has not
      invoiced NREL as of June 30, 2006, the company has not included this future
      unbilled appropriation as an asset as of June 30, 2006.





F-12





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





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





During
      2004 and 2005, the Company has received $1,000,000 in available appropriations
      for the purpose of continued testing and verification of our fuel additive.
      The
      Company submitted a proposal to NREL and expect to have these funds under
      contract by the end of the third quarter 2006. These projects would be eligible
      for 80% reimbursement.





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





In
      2003,
      the Company received an appropriation of $1,000,000 from the U.S. Department
      of
      Defense to test O2DieselTM fuel in non-strategic military vehicles operated by
      the U.S. Air Force at Nellis Air Force Base in Las Vegas, Nevada. Under the
      terms of this Appropriation, a third party is to be paid $200,000 to administer
      this program on behalf of the Department of Defense. The remaining $800,000
      is
      to be used to fund purchases of O2DieselTM fuel, certain capital equipment and to
      reimburse the Company for its labor, overhead and out-of-pocket costs required
      to complete this project. Under this program, the Company is required to meet
      certain milestones as a condition to receiving reimbursements for its costs.
      Thus, upon achieving a milestone, the Company accrues the amount due and submits
      an invoice for reimbursement. All amounts are expensed as incurred, and all
      amounts receivable for work completed are treated as a reduction to expense
      over
      the period earned. The period of performance for this program ran from
      October 7, 2003 to December 31, 2004. Through December 31, 2004,
      the Company had achieved five milestones and, since inception, has billed
      $360,000 related to this appropriation, of which $160,000 was billed in January,
      2005. By its terms, this contract expired on December 31, 2004 and will not
      be extended. No activity under this appropriation has taken place subsequent
      to
      March 31, 2005. The work required to achieve the milestones not completed
      as of December 31, 2004, has been included as part of the Statement of Work
      for Appropriation (2) from the U.S. Department of Defense as is permitted
      under that contract. However, the funds from Appropriation (1) cannot be
      applied to Appropriation (2). Through June 30, 2006, the Company has received
      cash in excess of costs incurred of $296,096 and has recorded Deferred Grants
      at
      June 30, 2006 in the Consolidated Balance Sheet. All amounts billed had been
      received as of June 30, 2006. No additional reimbursements are expected from
      this appropriation.





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





On
      January 11, 2005, the Company entered into a contract with a value of
      $1,085,000 with the U.S. Department of Defense. Under this contract, the
      Company’s O2DieselTM fuel is to be tested in a maximum of forty
      (40) non-tactical vehicles at US Air Force bases in Nevada for an
      18 month period. Furthermore, the Company is to complete certain engine
      testing and other work required for the acceptance of O2DieselTM as a viable
      alternative fuel for use by the Air Force. Work on this contract commenced
      on
      November 1, 2004 and is to continue through November 30, 2006.
      Notwithstanding that the agreement for this contract was signed in
      January 2005, the Company was asked to begin work in 2004 and, by a letter
      from Innovative Technologies Corporation (ITC), was authorized to incur costs
      in
      an amount not to exceed $75,000. This is a time and materials contract that
      is
      administered for the U.S. Department of Defense by a third party contractor.
      The
      Company charges all costs as incurred to expense and accrues all amounts
      receivable under the contract as a reduction to contract expenses. The contract
      amount was amended in May 2006 to $1,012,564. The amount of the reduction will
      be added to a future contract through the Air Force. Billings under this
      contract are made monthly. As of June 30, 2006, costs totaling $913,749 had
      been
      incurred; of which $738,156 had been billed of which $25,842 is included in
      other receivables as of June 30, 2006. In addition, the Company recorded
      $175,593 of unbilled receivables at June 30, 2006 under this appropriation.
      At
      June 30, 2006 there is $98,815 available in costs to complete the
      contract.





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





The
      Company received an appropriation during 2005 of approximately $910,000 from
      the
      Department of Defense. Concurrent Technologies Corporation (CTC) manages
      this appropriation on behalf of the Department of Defense. This contract
      contains a payment schedule based on meeting performance milestones. Three
      milestones were achieved by June 30, 2006. The primary objective of this
      contract is to create potential fuels using the Company additive that contain
      no
      more than 80% petroleum. If this project is successful, an application will
      be
      made to EPA for “alternative fuel” status, creating an incentive for federal
      customers to use the fuel. The Company billed $455,000 on this project during
      2006 based on the attained milestone(s) through that date of which $225,000
      is
      recorded as a receivable at June 30, 2006. Through June 30, 2006, the Company
      has recorded expenses of $99,566 against this contract and issued billings
      in
      excess of costs of $355,434 and has recorded Deferred Grants at June 30, 2006
      in
      the Consolidated Balance Sheet.





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





In
      2005,
      the Company received an appropriation of approximately $1,100,000 for continued
      testing and verification of O2DieselTM. The Company expects to receive a contract
      for this amount during the third quarter of 2006, and to begin the work
      immediately. The Company can receive reimbursement from this appropriation
      of up
      to the entire $1,100,000.





F-13





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**4.
      Other Receivables**




Other
        Receivables


June
                  30, 2006ITC
                  Appropriation
              
              $
              25,842NREL
                  Appropriation
              
              
              130,403CTC
                  Appropriation
              
              
              225,000Reimbursement
                  of patent legal expenses
              
              
              21,645$
              402,890




**5.
      Accrued Expenses**




Accrued
        Liabilities
  June
                  30, 2006Legal
                  and professional
              
              $
              95,308Investor
                  Relations
              
              
              45,193Other
              
              
              110,192$
              250,693




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





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





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





**7.
      Income Taxes**





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





Deferred
      income taxes reflect the net tax effects of temporary differences between the
      carrying amounts of assets and liabilities for financial reporting purposes
      and
      the amounts used for income tax reporting purposes. Significant components
      of
      the Company’s deferred tax asset as of June 30, 2006:




Income
                taxesNet
                operating loss carryforwards
            
            $
            7,806,000Deferred
                revenue
            
            
            309,000Accrued
                expenses
            
            
            170,000Total
                deferred tax assets
            
            
            8,285,000Valuation
                allowance
            
            
            (8,285,000
            )Net
                deferred tax assets
            
            $
            —




Management
      has determined that a valuation allowance equal to 100% of the existing deferred
      tax assets is appropriate given the uncertainty regarding the ultimate
      realization of these assets. At June 30, 2006, the Company had Federal and
      state
      net operating loss carryforwards of approximately $18.0 million for income
      tax purposes. If not used, these carryforwards expire through 2021 for Federal
      and state tax purposes. Federal tax rules impose limitations on the use of
      net
      operating losses following certain changes in ownership. If such a change
      occurs, the limitation would reduce the amount of the benefits that would be
      available to offset future taxable income each year, starting with the year
      of
      ownership change. As of June 30, 2006, the Company had an Irish net operating
      loss carryforward of approximately $520,000 which can be carried forward
      indefinitely, second quarter Spanish losses of approximately $140,000 which
      expire fifteen years after they are incurred, and a Brazilian net operating
      loss
      of approximately $1,275,000 that may be carried forward indefinitely, but which
      is subject to annual usage limitations.





F-14





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**8.
      Stockholders’ Equity**





**Recapitalization**





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





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





**Issuances
      of Common Stock**





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





During
      the second half of 2003, the Company received subscriptions for the issuance
      of
      754,900 additional shares of common stock in conjunction with a follow-on
      private placement. The Company received $952,350 in gross proceeds related
      to
      the subscriptions for 634,900 shares and recorded a subscription receivable
      of
      $180,000 related to the subscriptions for the remaining 120,000 shares. In
      the
      first quarter of 2004, the Company received subscriptions for the issuance
      of
      390,884 additional shares of common stock pursuant to the follow-on private
      placement. The Company received $386,325 in gross proceeds related to the
      subscriptions for the 390,884 shares, and it collected gross proceeds of
      $150,000 for subscriptions that it received in calendar year 2003. A
      subscription receivable of $230,001 was recorded as of March 31, 2004 to
      reflect advances of $30,000 for subscriptions received in calendar year 2003
      and
      $200,001 for subscriptions received in the first quarter of 2004. In the second
      quarter of 2004, the Company received gross proceeds of $50,001 related to
      subscriptions received in the first quarter of 2004, and cancelled and reversed
      the remaining balance of $180,000 in the subscription receivable account as
      of
      June 30, 2004. In total, the Company received $1,535,877 and issued
      1,025,784 shares of common stock pursuant to the follow-on private
      placement.





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





In
      January 2005, the Company retained a third party to raise, in a series of
      two private placements of the Company’s common stock, $5.0 million at a
      price of $0.70 per share. This offering price per share represented a discount
      from the market value of our common stock of approximately ten-percent (10%).
      The first private placement was for just under $2.0 million
      (“$2.0 million Private Placement”) and the second private placement was for
      just over $3.0 million (“$3.0 million Private Placement”, and together
      with the $2.0 million Private Placement, the “Private Placements”). As part
      of this transaction, the Company was obligated to comply with certain conditions
      in connection with the $2.0 million Private Placement and was also
      obligated to satisfy still other conditions applicable to the $3.0 million
      Private Placement. Further, the AMEX requires that shareholder approval be
      obtained by the Company for the sale of common stock in a transaction if the
      price of the shares to be sold is less than the greater of book or market value,
      and the number of shares equal 20% or more of the presently outstanding common
      stock. In order to comply with this requirement, the Company was required to
      seek shareholder approval for the $3.0 million Private Placement. No
      shareholder approval was required for the shares issued in conjunction with
      the
      $2.0 million Private Placement.





Pursuant
      to the $2.0 million Private Placement, the Company received qualified
      subscriptions for 2,803,428 shares of its common stock and total proceeds of
      $1,962,400 before payment of an 8% commission and other expenses. The parties
      subscribing to these shares agreed to waive certain of the conditions to permit
      the transaction to be closed as to their respective subscriptions. An initial
      closing for the $2.0 million Private Placement was held on March 17,
      2005 for 1,915,143 shares. A final closing for the remaining 888,285 shares
      was
      held on May 20, 2005.





F-15




O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





On
      June 10, 2005, an initial closing was held for the $3.0 million
      Private Placement covering 4,583,973 shares of common stock, for total proceeds
      of $3,208,781, before payment of an 8% commission and other expenses. In
      addition, the Company received additional subscriptions for 128,580 shares
      of
      its common stock and cash of $90,006, before payment of an 8% commission. As
      part of the terms for the $3.0 million Private Placement, the Company was
      required to satisfy two conditions in order to close the transaction. As
      indicated above, the first condition required that shareholder approval be
      obtained to issue the shares, and this was approved by the Company’s
      shareholders at its annual shareholder meeting held on May 31, 2005.
      Pursuant to the second condition, the Company was required to expand its senior
      management team, and it did so by creating the position of Chief Operating
      Officer and President. The Board of Directors (the “Board”) confirmed that both
      of these conditions had been satisfied as of May 31, 2005. On
      August 9, 2005, the Company received the final $89,874 (after expenses) for
      the $3.0 million Private Placement, and these transactions are now
      closed.





In
      total,
      the Company received $4,833,191 (after expenses) from the $2.0 million and
      $3.0 million Private Placements and it issued 7,515,981 shares of its
      common stock.





Subscribers
      to both of the Private Placements received one warrant to purchase one
      additional share of common stock for each two shares of common stock purchased.
      The warrant expires twenty-four months following the closing of the
      $2.0 million Private Placement and the $3.0 million Private Placement,
      respectively. Each warrant is exercisable at a price of $0.70 per share during
      the first twelve months following the close of each Private Placement, or at
      an
      exercise price of $1.05 per share in the second twelve months following the
      close of each Private Placement. The total number of warrants issued was
      3,757,990.





**$2.3
      Million Private Placement**





On
      September 20, 2005, the Company entered into a Common Stock and Warrant
      Purchase Agreement (“$2.3 million Purchase Agreement”) with a European
      investor (the “Purchaser”) for 3,228,070 shares of common stock at a purchase
      price of $0.7125 per share in a private placement for total proceeds of
      $2,300,000 (the “$2.3 million Private Placement”). As a condition of
      enforceability of the $2.3 million Purchase Agreement against the Company,
      the
      Purchaser was required to fund the purchase price in an escrow account, which
      funds were received on September 28, 2005.





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





As
      part
      of the transaction, the Company agreed to sell up to an additional $700,000
      of
      its common stock with detachable warrants to the Purchaser at a purchase price
      of $0.7125 per share, or 982,456 shares. This offer expired unexercised on
      March 20, 2006.





The
      Company agreed to issue warrants to purchase 1,614,035 shares of common stock
      at
      an exercise price of $0.7125 per share to its advisor in connection with this
      transaction. The warrants expire forty-two months after the date of
      issuance.





The
      transaction closed and the warrants were issued on October 24, 2005 and the
      funds were released from the escrow account on October 26, 2005. In
      addition, in connection with this transaction, the Company entered into an
      investor relations contract that awarded 100,000 shares of restricted common
      stock which vests over a one year period ending September 20, 2006. As of
      June 30, 2006, the restrictions on 81,250 shares issued under this contract
      have
      lapsed and such shares were earned and able to be sold.





**$3.6
      Million Private Placement**





On
      October 28, 2005, the Company entered into an agreement with a European
      producer of bioethanol to provide funding and commercial support to develop
      the
      European market for the Company’s products. The parties entered into a Common
      Stock and Warrant Purchase Agreement for 6,419,840 shares of the Company’s
      common stock in a private placement, for total proceeds of 3,000,000€, or
      approximately $3.6 million USD at the then current exchange rates. The
      Company agreed to use these funds exclusively for the development of the
      European market. The parties also entered into a Commercial Agreement, in which
      the investor and the Company will jointly develop the market for the Company’s
      products in Europe during a five year period. As part of the Commercial
      Agreement, the investor will be the exclusive supplier of the ethanol to be
      used
      in the blending of the Company’s product within the territory.





As
      part
      of the transaction, the Company issued warrants to purchase 2,853,262 shares
      of
      common stock at an exercise price of $0.85 per share during the period six
      to
      forty two months subsequent to the date of issuance or at an exercise price
      of
      $1.13 per share during the period forty three to sixty six months after the
      date
      of issuance. The warrants expire sixty six months after the date of issuance.
      The transaction closed and the funds were received on December 16,
      2005.





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





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





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





F-16





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





The
      purchase price of both transactions represented a discount of approximately
      10%
      in comparison to the prevailing market price of the Company’s Common Stock
      during the period of negotiations for these private placements.





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





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





**Issuances
      of Preferred Stock**





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





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





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





Each
      share of Series A Preferred Stock is convertible into shares of the
      Company’s common stock, at a variable 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 days preceding the date of conversion, but, in no
      case, less than twenty-five percent (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 A Preferred Stock will never receive more than
      8,000,000 or less than 2,000,000 shares of the Company’s common stock upon
      conversion of the Series A Preferred Stock.





Each
      share of Series B Preferred Stock is convertible into shares of the
      Company’s common stock, at a variable 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 days preceding the date of conversion, but, in no
      case, less than twenty-seven and four 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 B Preferred Stock will never
      receive more than 7,500,000 or less than 2,054,795 shares of the Company’s
      common stock upon conversion of the Series B Preferred Stock.





The
      Company determined that the intrinsic value of the beneficial conversion
      features embedded in the Series A and Series B Preferred Stock
      exceeded the proceeds from these preferred stock issuances. The Company accretes
      the value of the beneficial conversion feature through equity and records a
      deemed dividend to preferred stockholders. For the three and six month period
      ended June 30, 2006, the Company recorded a deemed dividend to preferred
      shareholders of $2,255,934 and $5,581,133 and for the period October 14,
      2000 (inception) through June 30, 2006 the Company recorded deemed
      dividends to preferred shareholders of $6,200,005 in the consolidated statements
      of operations.





F-17





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





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





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





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





**Warrants**





A
      wholly-owned subsidiary of the Company entered into a supply and distribution
      agreement (the “Distribution Agreement”) with a distributor dated July 10,
      2001 that granted the distributor the right to purchase up to 10% of the
      outstanding common stock of the Company for $1.00 per share should certain
      sales
      targets be achieved. The warrant was to expire on July 10, 2006. None of
      the sales targets have been achieved under the Distribution Agreement and as
      of
      December 10, 2004 this Distribution Agreement was terminated and replaced
      by a new supply and distribution agreement (the “New Agreement”). Under this New
      Agreement, the distributor received a warrant to purchase 600,000 shares of
      O2Diesel’s common stock at a price of $2.00 per share, which expires 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 an opportunity to exercise their warrants at the reduced
      price
      of $0.35 per share. On February 27, 2006, the Warrant Offering expired and
      the Company received proceeds of $592,692 (after expenses) for the exercise
      of
      warrants to purchase 1,864,035 shares of common stock. Between May 31-June
      12,
      2006, several other existing warrant holders elected to exercise their warrants
      at the contract price identified in their warrant documentation. Proceeds for
      these exercises were $865,452 (after expenses) for the purchase of 1,287,857
      shares of common stock.





**Options**





The
      Company implemented a Stock Incentive Plan (the “Incentive Plan”) in 2004 for
      which the Board of Directors has authorized 7,212,957 shares of common stock
      to
      be reserved for future issuance under the Incentive Plan. At December 31,
      2005 the Company had committed to award 7,750,000 options to purchase common
      stock to certain officers, employees and directors, of which 5,950,000 options
      have been approved and granted by the Board of Directors. As of June 30, 2006,
      one employee who had been promised (but not granted) 600,000 options left the
      employment of the Company and forfeited the promised options. Four other
      employees received new promises for 350,000 options, resulting in net
      commitments from the Company of 7,500,000 options to purchase common stock.
      The
      Company expected to obtain approval from the shareholders during 2006 to
      increase the number of common shares available for issuance under the Incentive
      Plan in order to effectuate the grant of the remaining stock options committed
      to plan participants. On July 6, 2006, this approval was obtained at the
      Company’s annual shareholder meeting and the additional options were granted by
      the Board of Directors.





The
      Company will issue options to the following groups in the third
      quarter:




Director
            
            
            200,000Employees
                & Consultants
            
            
            1,350,0001,550,000




In
      accordance with the Incentive Plan, the Company expects the options to be
      awarded at various stages of vesting.





F-18





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





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




**Weighted
                Ave****Weighted
                Ave**
            
            **Remaining****Shares**
            
            **Exercise
                Price**
            
            **Contractual
                Term**Outstanding
                at January 1, 2004
            
            
            500,000
            
            $
            1.50Granted
                in 2005
            
            
            5,450,000
            
            $
            1.50
            
            
            9.8Exercised
                in 2005Forfeited
                or ExpiredOutstanding
                at December 31, 2005
            
            
            5,950,000
            
            $
            1.50
            
            
            9.7Granted
                During the Six Months Ended June 30, 2006Exercised
                During the Six Months Ended June 30, 2006Forfeited
                or ExpiredOutstanding
                at June 30, 2006
            
            
            5,950,000
            
            $
            1.50
            
            
            9.4Exercisable
                at June 30, 2006
            
            
            5,950,000
            
            $
            1.50
            
            
            9.2




**Restricted
      Stock Awards**





On
      September 20, 2005, the Company entered into an investor relations
      consulting agreement for a term of one year. In exchange for services, the
      Company will pay the consultant $7,290 per month. In addition, the Company
      awarded the consultant 100,000 shares of restricted stock. In connection with
      the stock award, the Company recognized $30,500 of consulting expense in 2005.
      Pursuant to the terms of the consulting agreement, 75,000 shares of the
      restricted stock is earned by the consultant ratably over the term of the
      agreement. As of June 30, 2006, the restrictions on 81,250 shares issued under
      this contract have lapsed and such shares were earned and able to be
      sold.





The
      following schedule presents shares of common stock issued and outstanding and
      reserved for future issuance as of June 30, 2006:




Common
                Shares Outstanding
            
            
            73,734,522Restricted
                Common Shares For Consultant
            
            
            18,750
            
            
            73,753,272Reserved
                For Future IssuanceOptions
                Granted to officers and directors
            
            
            5,950,000Options
                Promised Directors, Employees and Consultants
            
            
            1,550,000Restricted
                stock to employees and consultants
            
            
            500,000Warrants
            
            
            11,620,765
            
            
            19,620,765Total
                shares issued and outstanding and reserved for future
                issuance
            
            
            
            
            
            93,374,037





**9. Related
      Party Transactions**





A
      company
      controlled by the former Chairman of the Board provides office space, accounting
      and other services to the Company at a cost of approximately $2,500 per month.
      The Company paid $5,397 and $13,579 for the three and six months ended June
      30,
      2005 and paid $10,284, $10,284 and $174,630 respectively for the three and
      six
      months ended June 30, 2006 and for the period October 14, 2000
      (inception) through June 30, 2006, to the company controlled by the former
      Chairman. The company has accrued $7,500 for services performed for the three
      months ended through June 30, 2006 that are still unpaid.





Included
      in receivables due from related parties at June 30, 2006 is $45,788 which is
      related to travel advances made to employees and directors.





The
      Company has entered into two separate consulting contracts with two shareholders
      of its Brazilian subsidiary for the purpose of providing office rent and
      administrative services and in lieu of employment contracts with these two
      individuals. These two contracts provide support significant to the operation
      of
      the Brazilian subsidiary. The company incurred expenses of $52,817 and $172,916
      for the three and six months ended June 30, 2005 and $42,607, $99,708 and
      $391,092 for the three and six months ended June 30, 2006 and for the period
      October 14, 2000 (inception) through June 30, 2006.





F-19





O2Diesel
      Corporation


(A
      Development Stage Company)


Notes
      to
      Financial Statements





**10.
      Commitments**





**Operating
      leases**





The
      Company leases office space and certain office equipment under agreements that
      are accounted for as operating leases. As of June 30, 2006, future minimum
      lease
      payments under non-cancelable operating leases expiring through 2008, were
      as
      follows:





Operating
      Leases




2006
            
            $
            46,5342007
            
            
            83,7752008
            
            
            78,680Total
            
            $
            208,989





Rent
      expense under the leases with unrelated parties was $19,082 and $38,665 for
      the
      three and six months ended June 30, 2005 and was $26,799, $53,098 and $225,273
      respectively for the three and six months ended June 30, 2006 and for the period
      October 14, 2000 (inception) through June 30, 2006.





**Truck
      Loan**





On
      November 4, 2004, the Company purchased a diesel truck to be used for
      product testing and analysis. The cost of this vehicle was $26,545. Subsequent
      to this purchase, the Company financed $23,000 with a local bank, and the loan
      was secured by the truck. The note bore interest at 7.00 % and was payable
      in
      24 monthly installments of $1,031 with the final payment due in
      November 2006. The Company disposed of the truck in November 2005 and
      received proceeds of $11,900 which were used to pay off the balance of the
      loan.





**11.
      Subsequent Events**





The
      Company’s Annual Meeting of shareholders was held on July 6, 2006 in Newark,
      Delaware. Of the 72,465,415 shares of common stock outstanding as of the record
      date of May 30, 2006, 48,081,289 shares, or 66.4% of the Company’s capital
      stock, were present or represented by proxy at the meeting, constituting a
      quorum.





The
      following proposals were approved by the shareholders:





1.
            Elect
                Mr. David L. Koontz, Mr. Gerson Santos-Leon and Mr. Jeffrey L. Cornish
                as
                Class B directors to hold office until the 2009 annual meeting of
                stockholders or until their respective successors are duly elected
                and
                qualified,





2.
            Ratify
                and approve the issuance of shares of Common Stock in connection
                with a
                private placement of Common Stock to accredited investors to the
                extent
                that such issuance would require shareholder approval under the rules
                of
                AMEX;





3.
            Ratify
                the appointment of Mayer Hoffman McCann P.C. to serve as the Company’s
                independent registered public accounting firm for the fiscal year
                ending
                December 31, 2006;





4.
            Approve
                an amendment to increase the number of shares authorized under the
                O2Diesel Corporation 2004 Stock Incentive Plan;
                and





5.
            Approve
                an amendment to the Company’s Certificate of Incorporation to increase the
                number of shares authorized.





At
      a
      subsequent meeting of the Board on July 6, 2006, the Board voted to grant
      1,550,000 options to employees, consultants and a director, which was announced
      in a Form 8-K filed on July 12, 2006. The Company also approved the Form of
      Incentive Stock Option Agreement for options granted to officers, directors
      and
      employees, which was filed in a Form 8-K/A filed on July 28, 2006.





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company has regained compliance with AMEX listing requirements.





F-20





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





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





**OVERVIEW**





**Business
      Plan**





**Overview**





The
      Company is classified as a development stage company as shown on its unaudited
      consolidated financial statements for the period from inception
      (October 14, 2000) through June 30, 2006.





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





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





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




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





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





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





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





Each
      share of Series A Preferred Stock is convertible into shares of the
      Company’s common stock, at a variable 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 days preceding the date of conversion, but, in no
      case, less than twenty-five percent (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 A





Preferred
      Stock will never receive more than 8,000,000 or less than 2,000,000 shares
      of
      the Company’s common stock upon conversion of the Series A Preferred
      Stock.





Each
      share of Series B Preferred Stock is convertible into shares of the
      Company’s common stock, at a variable 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 days preceding the date of conversion, but, in no
      case, less than twenty-seven and four 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 B Preferred Stock will never
      receive more than 7,500,000 or less than 2,054,795 shares of the Company’s
      common stock upon conversion of the Series B Preferred Stock.





1





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





The
      Company determined that the intrinsic value of the beneficial conversion
      features embedded in the Series A and Series B Preferred Stock
      exceeded the proceeds from these Preferred Stock issuances. The Company accretes
      the value of the beneficial conversion feature through equity and records a
      deemed dividend to preferred stockholders. For the three month and six month
      periods ended June 30, 2006, the Company recorded deemed dividends to preferred
      shareholders of $2,255,934 and $5,581,133. For the period October 14, 2000
      (inception) through June 30, 2006 the Company recorded deemed dividends to
      preferred shareholders of $6,200,005 in the consolidated statements of
      operations, which represents the complete recognition of deemed dividends.





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





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





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





**Listing
        of Common Stock on
        AMEX**


On
      June 15, 2004, the American Stock Exchange (“AMEX” or “Exchange”) approved
      an application to list 46,518,898 shares of our common stock under the symbol
      OTD. Subsequent to this date, the Exchange has approved additional applications
      to list 45,985,710 more shares of our common stock so that the total number
      of
      shares approved for listing is 92,504,608. Our shares began to trade on the
      Exchange on July 1, 2004.




The
      Company’s audited consolidated financial statements for the year ended
      December 31, 2005, were prepared on a going concern basis, which
      contemplates the realization of assets and the settlement of liabilities and
      commitments in the normal course of business. Our independent registered public
      accounting firm included an explanatory paragraph in their report on the
      December 31, 2005 audited consolidated financial statements to highlight
      that the Company’s accumulated losses and working capital deficit raised
      substantial doubt about the Company’s ability to continue as a going
      concern.





The
      Company’s unaudited financial statements for the three and six months ended June
      30, 2006 have been prepared on a going concern basis, which contemplates the
      realization of assets and the settlement of liabilities and commitments in
      the
      normal course of business. At June 30, 2006, the Company had a working capital
      surplus of $8,221,075 and had accumulated losses of $28,981,677.





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





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





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





As
      described later in this section, the Company closed an offer to existing warrant
      holders to exercise their warrants at a reduced price for proceeds of $592,692
      (after expenses) as part of its efforts to meet these requirements. Subsequent
      to this closing, several other existing warrant holders elected to exercise
      their warrants at the contract price identified in their warrant documentation.
      Proceeds for these exercises were $865,452 (after expenses). In addition, the
      Company closed two private placements totaling $6.5 million as part of this
      effort.





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





2





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





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





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company has regained compliance with AMEX listing requirements.




**$2.0
      and $3.0 million Private
      Placements**





In
      January 2005, the Company retained a third party to raise, in a series of
      two private placements of the Company’s common stock, $5.0 million at a
      price of $0.70 per share. This offering price per share represented a discount
      from the market value of the Company’s common stock of approximately ten-percent
      (10%). The first private placement was for just under $2.0 million
      (“$2.0 million Private Placement”) and the second was for just over
      $3.0 million (“$3.0 million Private Placement”, and together with the
      $2.0 million Private Placement, the “Private Placements”). As part of these
      transactions, the Company was obligated to comply with certain conditions in
      connection with the $2.0 million Private Placement, and the Company was
      also obligated to satisfy still other conditions applicable to the
      $3.0 million Private Placement.





The
      AMEX
      requires that shareholder approval be obtained by the Company for the sale
      of
      common stock in a transaction if the price of the shares to be sold is less
      than
      the greater of book or market value, and the number of shares equal
      twenty-percent (20%) or more of the presently outstanding common stock. In
      order
      to comply with this requirement, the Company was required to obtain shareholder
      approval for the $3.0 million Private Placement. No shareholder approval
      was required for the shares to be issued in conjunction with the
      $2.0 million Private Placement.





Pursuant
      to the $2.0 million Private Placement, the Company received qualified
      subscriptions for 2,803,428 shares of our common stock for total proceeds of
      $1,962,400, before payment of an 8% commission and other expenses. The parties
      subscribing to these shares agreed to waive certain of the conditions to permit
      the transaction to be closed as to their respective subscriptions. An initial
      closing for the $2.0 million Private Placement was held on March 17,
      2005 for 1,915,143 shares. A final closing for the remaining 888,285 shares
      was
      held on May 20, 2005.





On
      June 10, 2005, the Company held an initial closing for the
      $3.0 million Private Placement covering 4,583,973 shares of its common
      stock, for total proceeds of $3,208,781, before payment of an 8% commission
      and
      other expenses. In addition, the Company received additional subscriptions
      for
      128,580 shares of our common stock and funds of $90,006, before payment of
      an 8%
      commission. As part of the terms for the $3.0 Private Placement, the Company
      was
      required to satisfy two conditions in order to close the transaction. As
      indicated above, the first condition required that the Company obtain
      shareholder approval to issue these shares, and this was approved by the Company
      shareholders at our annual shareholder meeting held on May 31, 2005.
      Pursuant to the second condition, the Company was required to expand our senior
      management team, and the Company did so by creating the position of Chief
      Operating Officer and President. The Board of Directors (the “Board”) confirmed
      that both of these two conditions had been satisfied as of May 31, 2005. On
      August 9, 2005, the Company received the final $89,874 (after expenses) for
      the $3.0 million Private Placement, and these transactions are now
      closed.





In
      total,
      the Company received $4,833,191 (after expenses) from the Private Placements
      and
      it issued 7,515,981 shares of its common stock.





Subscribers
      to both the Private Placements received, for each two shares of common stock,
      one warrant to purchase one additional share of common stock. The warrant
      expires twenty-four months following the closing of the $2.0 million
      Private Placement and $3.0 million Private Placement, respectively. Each
      warrant is exercisable at a price of $0.70 per share during the first twelve
      months following the close of each Private Placement, or at an exercise price
      of
      $1.05 per share in the second twelve months following the close of each Private
      Placement. The total number of warrants to be issued was 3,757,990.




**$2.3
      million Private
      Placement**





On
      September 20, 2005, the Company entered into a Common Stock and Warrant
      Purchase Agreement (“$2.3 million Purchase Agreement”) with a European
      investor (the “Purchaser”) for 3,228,070 shares of common stock at a purchase
      price of $0.7125 per share in a private placement for total proceeds of
      $2,300,000. As a condition of enforceability of the $2.3 million Purchase
      Agreement against the Company, the Purchaser was required to fund the purchase
      price in an escrow account, which funds were received on September 28,
      2005.





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





As
      part
      of the transaction, the Company agreed to sell up to an additional $700,000
      of
      its common stock with detachable warrants to the Purchaser at a purchase price
      of $0.7125 per share for 982,456 shares. The offer expired unexercised on
      March 20, 2006.





The
      Company agreed to issue warrants to purchase 1,614,035 shares of common stock
      at
      an exercise price of $0.7125 per share to its advisor in connection with this
      transaction. The warrants expire forty-two months after the date of
      issuance.





The
      transaction closed and the warrants were issued on October 24, 2005 and the
      funds were released from the escrow account on October 26, 2005. In
      addition, in connection with this transaction, the Company entered into an
      investor relations contract that awarded 100,000 shares of restricted common
      stock which vests over a one year period ending September 30, 2006. As of
      June 30, 2006, the restrictions on 81,250 shares issuable under this contract
      have lapsed and such shares were earned and able to be traded.





3





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





**$3.6 million
      Private Placement**




On
      October 28, 2005, the Company entered into an agreement with a European
      producer of bioethanol to provide funding and commercial support to develop
      the
      European market for the Company’s products. The parties entered into a Common
      Stock and Warrant Purchase Agreement for 6,419,840 shares of the Company’s
      common stock in a private placement, for total proceeds of 3,000,000€, or
      approximately $3.6 million USD at the then current exchange rates. The
      Company agreed to use these funds exclusively for the development of the
      European market. The parties also entered into a Commercial Agreement, in which
      the investor and the Company will jointly develop the market for the Company’s
      products in Europe during a five year period. As part of the Commercial
      Agreement, the investor will be the exclusive supplier of the ethanol to be
      used
      in the blending of the Company’s product within the territory.





As
      part
      of the transaction, the Company issued warrants to purchase 2,853,262 shares
      of
      common stock at an exercise price of $0.85 per share during the period six
      to
      forty two months subsequent to the date of issuance or at an exercise price
      of
      $1.13 per share during the period forty three to sixty six months after the
      date
      of issuance. The warrants expire sixty six months after the date of issuance.
      The transaction closed and the funds were received on December 16,
      2005.





**$4.0
      and $2.5 million Private Placements**




On
      April
      6, 2006, the Company entered into a Common Stock and Warrant Purchase Agreement
      (“$4.0 million Purchase Agreement”) with a UK investor (the “Purchaser”)
      for 5,333,333 shares of common stock at a purchase price of $0.75 per share
      in a
      private placement for total proceeds of $4,000,000 (the “Private Placement”). As
      part of this sale, the Company also issued warrants to purchase 2,666,667 shares
      of common stock at an exercise price of $.825 per share during the period of
      six
      months to forty-two months subsequent to issuance. The warrants expire forty-two
      months after the date of issuance. The Purchaser’s obligation to purchase the
      shares was subject to the Company satisfying certain additional
      conditions.





Also
      on
      April 6, 2006, the Company entered into a Common Stock and Warrant Purchase
      Agreement (“$2.5 million Purchase Agreement”) with a different European
      investor (the “Purchaser”) for 3,333,333 shares of common stock at a purchase
      price of $0.75 per share in a private placement for total proceeds of $2,500,000
      (the “Private Placement”) before payment of a 9% commission and other expenses.
      As part of this sale, the Company also issued warrants to purchase 1,666,667
      shares of common stock at an exercise price of $.825 per share during the period
      of six months to forty-two months subsequent to issuance. The warrants expire
      forty-two months after the date of issuance. The Purchaser’s obligation to
      purchase the shares was subject to the Company satisfying certain additional
      conditions.





The
      purchase price of both transactions represented a discount of approximately
      10%
      in comparison to the prevailing market price of the Company’s Common Stock
      during the period of negotiations for these private placements.





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





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




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




**Operations**





During
      the second quarter of 2006, we continued our efforts to generate sales to our
      targeted fleet customers in North America and Brazil.





United
      States and Canada:





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





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




4





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





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





In
      the
      second quarter of 2006, the Company experienced continued commercial success
      with its activities at the Port of Long Beach and is currently pursuing
      additional opportunities in this market segment. The Company also continued
      its
      successful test demonstration with the military at US Air Force bases in Nevada.
      Our other test demonstrations at a large coal mining operation in Wyoming and
      a
      municipal waste fleet in California have been maintained as well.





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





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





In
      the
      second quarter of 2006, we had four cities using O2DieselTM in CityHomeTM
installations, and we were in discussion with several others to participate
      in
      the program. To date, we have used this initiative as an important component
      of
      our test/demonstration strategy and have been successful in attracting fuel
      distributors to work with us in getting this initiative started. However, while
      we have received sponsorship funding for our current CityHomeTM programs, the
      current fleet demonstrations being executed under this program have continued
      to
      require significant financial support from the Company. As a result, during
      the
      second quarter we have decided to limit new CityHomeTM programs to instances
      where we are assured of a level of sponsorship funding needed to cover all
      expenses of the demonstration. In addition, our participation in one of our
      CityHome fleets (Des Moines) was reduced to a small number of vehicles due
      to
      issues relating to continued water contamination of the fuel supplied to this
      fleet.





We
      have
      also expanded our efforts to establish and improve the logistics network
      required for the delivery of O2DieselTM to fleet and CityHomeTM customers in the
      second quarter of 2006. These efforts have centered on developing strategic
      relationships with ethanol producers and distributors in order to improve both
      quality consistency and price stability. In June 2006, the Company succeeded
      in
      negotiating a supply agreement with an ethanol industry group to obtain a supply
      of limited amounts of ethanol at preferential pricing for our Midwestern
      customers.





During
      the second quarter of 2006, we pursued additional discussions and initiatives
      in
      Europe to both test our fuel and to determine the market size and acceptance
      of
      our fuel for use in Europe. These discussions involved municipal transit
      systems, a waste truck fleet and a port facility. We expect these activities
      to
      continue for the remainder of 2006.





We
      are
      continuing a series of product tests and demonstrations that relate directly
      to
      obtaining regulatory approval for O2DieselTM and which are designed to meet the
      needs of our targeted customers. During the quarter ended June 30, 2006, the
      Company initiated an effort to register O2DieselTM fuel with the EPA and
      continued to conduct a revised series of tests to qualify O2DieselTM as a
      California Diesel Emissions Control Strategy both as a stand alone fuel and
      in
      conjunction with various exhaust after treatment devices, such as both direct
      oxidation catalysts (DOC’s) and Diesel Particulate Filters (DPF’s). In addition,
      we drafted a specification for our fuel for the purpose of proposing a ballot
      for incorporation of this fuel as an American Society for Testing and Materials
      (ASTM) specification later in 2006. This work has taken longer than originally
      anticipated, and final regulatory approvals for these submissions are not
      expected prior to the end of 2006.





Finally,
      during the second quarter of 2006 we began the application process with NREL
      to
      expand the use of our government grant funding in both current and proposed
      fuel
      demonstrations as a means of increasing our test data and practical experience.





5





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





Brazil:





In
      Brazil, O2Diesel is targeting customers on a very focused basis. In general,
      these will be miller fleets (sugar and ethanol producers), municipal bus and
      other fleets, and to a lesser extent centrally fueled truck fleets. We have
      established a small sales force and technical staff in Brazil. The roll out
      of
      our product has been much slower than planned. Obtaining government approvals
      and gaining market awareness has taken longer than we anticipated. In response
      to these matters, we have made a decision to follow a less aggressive marketing
      strategy for Brazil. We have taken steps to reduce our overhead and scaled
      back
      our marketing plans until we have a solid base of customers in
      Brazil.





Brazil’s
      fuel distribution 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
      and
      deliver O2DieselTM to customers in Brazil. In January 2005, we signed a
      Memorandum of Understanding with a company reported to be the sixth largest
      fuel
      distributor in Brazil. This company was to serve as our exclusive distributor
      for O2DieselTM in the South and Southeastern regions of Brazil. This Memorandum
      of Understanding is no longer in place, since O2Diesel has decided to cooperate
      on a non-exclusive basis with Brazil’s largest fuel distributor, BR, the
      distribution arm of the state-owned mineral oil company Petrobrás. BR/Petrobrás
      is to supply readily blended O2Diesel fuel to the municipality of Rio de
      Janeiro. Failure to attract additional distribution partners to cover other
      parts of Brazil will likely set back our timetable for achieving market
      penetration in that country.





Technical
      and Logistical Issues





Significant
      technical and logistical issues continued to affect our ability to generate
      sales in the second quarter of 2006. While we have made substantial progress
      in
      addressing these challenges over the course of the year, they have impeded
      our
      efforts to commercialize O2DieselTM fuel. In general, these challenges fall into
      the following categories: (1) logistics of delivering and dispensing
      O2DieselTM, (2) sourcing and installation of flame arrestors and other
      devices in vehicles and storage facilities, (3) negotiating reliable,
      price-competitive supplies of fuel grade ethanol, (4) insuring that fuel
      tanks are appropriately cleaned, and (5) obtaining regulatory approval and
      an
      industry accepted specification for our “e-diesel” (ethanol-diesel) fuel.
      O2Diesel has devised several strategies to meet these challenges and has
      undertaken a variety of activities to overcome these challenges and to position
      O2DieselTM as a premium clean-burning fuel.





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





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





Secondly,
      as part of the process by which O2DieselTM was approved for sale in California,
      the California Air Resources Board set a number of conditions that we must
      adhere to on an ongoing basis. One of the conditions is that all storage tanks
      in which O2DieselTM is stored and all vehicles that use the fuel must be fitted
      with devices known as flame arrestors. Flame arrestors are safety devices which
      are intended to prevent a fire in case a spark or other type of ignition might
      inadvertently enter the fill inlet of a fuel tank. Imposing this requirement
      proved to be a serious issue in 2004 and early 2005, and has negatively impacted
      our ability to efficiently commercialize our technology in the U.S. Even though
      flame arrestor technology has been used for many years in other applications,
      flame arrestors in the required sizes and designs were not yet available as
      an
‘off the shelf item’ for use with O2DieselTM during this time.





Third,
      we
      have confirmed that it is important to carefully select ethanol suppliers
      because there is a wide range of fuel grade ethanol in the marketplace. It
      is
      critical that the ethanol component of O2DieselTM be of a consistently high
      quality and that it meet certain other specifications. Selection of ethanol
      suppliers and creating a relationship with those that can provide the quality
      of
      product we require is a significant need, and is a task that we will devote
      more
      time to during the remainder of 2006. We are currently working closely with
      the
      industry to identify ethanol suppliers who meet our criteria.





6





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





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





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





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





The
      Company has taken several steps in 2005 and 2006 to overcome these problems
      and
      to support the introduction of O2DieselTM fuel to new customer opportunities.
      First, we assembled our knowledge and documentation regarding the design
      requirements of flame arrestors in the market areas we served and developed
      a
      catalogue of flame arrestors and parts that can be used for a wide variety
      of
      engine/vehicle types and customer applications. Second, we developed a checklist
      of procedures to be used by our technicians (in conjunction with our customer)
      that enabled our technicians to prepare a comprehensive fleet profile of
      hardware requirements, tank cleaning procedures and the time required to perform
      the work necessary to bring a fleet on-line. Third, we have identified several
      equipment vendors who we plan to work with so that needed equipment can be
      delivered to customer locations quickly and at competitive prices. Fourth,
      we
      have developed a training program that will enable our technicians to teach
      our
      customer’s fleet maintenance staff about handling and storing O2DieselTM fuel,
      fleet modification and maintenance issues that can be expected. Finally, we
      have
      developed a modest parts inventory at our laboratory facility so that in the
      event of an emergency, required parts can be supplied to our
      customers.





Our
      present planning methodology is based on a 40-day implementation time frame
      that
      requires the project to be a joint effort utilizing the customer’s employees and
      identifies the timing and costs that the customer can expect. During 2005,
      we
      continued the research and development efforts begun in 2004 to design and
      to
      identify flame arrestors, adaptors and other equipment for vehicles that use
      O2DieselTM. Some of these devices have undergone and passed tests to insure that
      they are capable of complying with all required specifications. In 2006, other
      flame arrestors will be developed and subjected to the required tests. In
      addition, we have learned that certain engines require the fitting of a primer
      pump to insure that the vehicle starts and runs properly in hot weather. These
      devices are simple and readily available and the costs are known, but the
      necessity of adding these devices to certain vehicles could increase our costs
      and may increase the time required to transition a fleet from using regular
      diesel fuel to the use of O2DieselTM. Lastly, in some buses, we have had to
      install safety fueling devices in the fuel inlet that serve the function of
      flame arrestors, but are generally more expensive. These particular devices
      are
      readily available in the market. To support our implementation efforts, we
      commissioned a third party engineering consulting firm to review our written
      safety training procedures as well as to conduct on-site reviews of four of
      our
      customer locations in order to evaluate the adequacy of the training and the
      quality of safety procedure implementation. The ensuing report from the
      consultant indicated that our safety program requirements were well conceived
      and were being followed quite closely at all locations. Additional safety
      procedures to enhance this program are currently being evaluated.





All
      of
      these issues have led to a greater lead time than expected to convert a fleet
      from using regular diesel to O2DieselTM. In fact, we have seen that the time it
      takes to do the conversion work can be the most important factor in bringing
      on
      more customers to use our fuel. As a means of mitigating the time required
      for
      converting a fleet, we have sought to have our customers to complete much of
      this work under our direction. However, this policy is dependent upon obtaining
      an agreement from the customer to do the work. The actual time required to
      convert a fleet to use O2DieselTM may be further limited by the availability of
      the customers’ vehicles to be in one place long enough to effect the required
      changes. In some cases for safety, insurance or union reasons, customers will
      require that they complete all of the work necessary for their vehicles and
      diesel powered equipment to use O2DieselTM, as well as arranging to insure that
      their storage and dispensing facilities are compatible with the use of the
      fuel.
      The Company anticipates that the work achieved in 2005 and in the first half
      of
      2006 will allow us to bring all of these factors into the implementation
      planning process so that we can avoid the costs and delays we experienced in
      the
      past.





7





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





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





**Second
      Quarter Summary**





Operating
      results during the six month period ended June 30, 2006 showed mixed
      results in comparison to those during the six month period ended June 30, 2005.
      Sales improved modestly from $44,064 (six months ended June 30, 2005) to $68,500
      (six months ended June 30, 2006) due in large part to the implementation of
      our
      CityHomeTM programs. Cost of goods increased relative to sales due to an increase
      in the costs of the raw material components used to manufacture our additive.
      However, increased selling prices at one customer and lower shipping costs
      resulted in a modestly improved operating margin. Selling and marketing expenses
      for the period ended June 30, 2006 were nearly $250,000 lower than during the
      period ended June 30, 2005, reflecting the reduction in expenses to support
      the
      CityHomeTM programs that are now running. Product testing and government grant
      expenses (net) in the six months ended June 30, 2006 were approximately $130,000
      lower than in the period ended June 30, 2005 due to an increase in billings
      to
      the contractors, an improvement in the Company’s internal processing of these
      charges and a reduction in laboratory expenses. General and administrative
      expenses for the six months ended June 30, 2006 were approximately $920,000
      higher than for the six months ended June 30, 2005 due to the greater payroll,
      fringe benefits and travel expenses related to an increase in staff of six
      employees and higher liability insurance costs in comparison to the period
      ended
      June 30, 2005, as well as the recognition of $175,623 in share-based
      compensation required by SFAS 123(R).





**Cash
      Requirements, Liquidity and Risk Factors**





Based
      on
      our projected level of expenses and the cash on hand as shown on our
      consolidated balance sheet at June 30, 2006, we will need to raise additional
      funds in 2006. Even with the capital raised in 2005 and early 2006, we believe
      it will be necessary to raise additional funds in 2006 to allow us to execute
      our business plan and to be in compliance with the AMEX’s listing
      standards.





To
      date,
      we have not had any bank trade facilities, except an overdraft line in the
      U.K.
      used to meet operating needs and a small vehicle loan. This overdraft facility
      was repaid and canceled during 2003 and the vehicle loan was paid off in
      November 2005. However if the Company achieves significant sales, we plan
      to apply for trading lines with banks in the U.S. and Brazil as a means to
      finance our working capital needs. In the second quarter of 2006, the Company
      continued to have favorable trade terms with its supplier, Cognis Deutschland
      GmbH (“Cognis”) for the supply of additive.





AMEX
      requires that minimum levels of stockholders’ equity be maintained. O2Diesel was
      not in compliance because its stockholders’ equity had dropped below the
      required minimums, and it had experienced continuing losses for the past four
      years. In order to return to full compliance, O2Diesel needed to have
      stockholders’ equity of $6.0 million by June 2006. In accordance with
      the procedures of the AMEX, we filed a plan (“Plan”) with it to demonstrate the
      steps we will take to return to full compliance. On February 15, 2005, the
      AMEX notified us that it had accepted our Plan, and that we would be given
      until
      June 2006 in which to regain compliance with the AMEX’s listing rules. To
      achieve that level of stockholders’ equity, we anticipated having to raise a
      total of approximately $10.0 million in new equity during 2005. In December
      2005 the Company determined that it could not meet certain conditions of the
      plan and met with representatives of the AMEX to discuss the need to develop
      an
      amended plan to demonstrate how the Company would be in compliance by
      June 2006.





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





As
      described earlier in this section, the Company closed an offer to existing
      warrant holders to exercise their warrants at a reduced price for proceeds
      of
      $592,692 (after expenses) as part of its efforts to meet these requirements.
      Between May 31 and June 12, 2006, several other existing warrant holders elected
      to exercise their warrants at the contract price identified in their warrant
      documentation. for proceeds of $865,452 (after expenses). In addition, as
      described more fully above, the Company closed two private placements totaling
      $6.5 million as part of this effort. On July 17, 2006, the Company received
      a letter from the AMEX indicating that the Company has regained compliance
      with
      AMEX listing requirements.





8





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





As
      a
      result of the lack of a sales history for our products, we do not have
      sufficient historical financial data for any periods on which to accurately
      forecast future revenues or operating expenses in connection with achieving
      such
      revenues. As such, we are not able to project with certainty the additional
      funds that may need to be raised. In 2005, we raised new equity of approximately
      $11.1 million, before payment of expenses. As stated previously, even with
      the fund raising completed in 2005, and the $8.0 million raised during the
      first
      half of 2006, we will need to raise additional equity in 2006. We continue
      to
      hold discussions with a number of potential investors and work with a
      professional investor relations service company to assist with these efforts.
      In
      connection with our efforts to attract new investment, there can be no assurance
      that we will be successful in doing so. Nor can there be any assurance that
      the
      Company will generate sales and sponsorship fees followed by the collection
      of
      cash to offset our operating expenses.





As
      shown
      in the consolidated statements of operations contained in this report, we have
      generated only $30,375 and $68,500 in sales and had sponsorship income of
      $24,249 and $36,996 associated with the CityHomeTM programs for the three and six
      months ended June 30, 2006. As of the date of this report, we have only minimal
      orders on hand for either O2D05 or O2DieselTM. Lastly, there can be no assurance
      that actual events will not differ from those anticipated, or that general
      economic conditions may not vary significantly in ways that could negatively
      impact our operations and cash position.





**Research
      & Development**





As
      part
      of our cooperation agreement with Cognis, we, along with Cognis, are the joint
      owners of all patents covering both the use and composition of O2D05. Patent
      applications have been filed in twelve countries for O2D05, including the U.S.,
      Canada, Brazil, and Europe. For this purpose, Europe is counted as one country.
      As such, the patent application for Europe covers 20 countries, including the
      more populous countries of the U.K., France, Germany, Italy and Spain. The
      patent applications for the U.S., Brazil and Canada are pending.





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





We
      have
      filed trademark registration applications in the U.S. and the European Union
      for
      a mark which includes the words and numbers O2Diesel as well as a figurative
      logo of the words.





As
      mentioned earlier, we developed a new marketing initiative in 2004 which is
      styled as CityHomeTM. On November 11, 2004, we filed applications for the
      trademark “CityHome” (and design) in eight classes of goods and services. Final
      approval of the trademark was received in April 2006. An application was
      also filed for the trademark “TODAY’S CLEAN AIR SOLUTION TOMORROW’S BRIGHTER
      FUTURE” covering one class of goods and services.





During
      2005, we incurred substantial costs in carrying out tests to demonstrate that
      the use of our product will enable customers to comply with environmental laws
      and regulations. More specifically, through June 30, 2006, we incurred external
      expenses of $1,679,262 in the U.S. in connection with governmental sponsored
      projects and tests. Most of the costs incurred in these government test programs
      were reimbursed by appropriations from the U.S. Departments of Energy and
      Defense.





Throughout
      the first half of 2006, we had government test programs in progress with total
      remaining costs to complete of approximately $1.6 million. Under these
      programs, a wide array of engine tests and product demonstrations are to be
      conducted to further prove the emissions benefits of O2DieselTM and to show that
      the fuel performs well in specific applications.





Included
      in the foregoing programs are product demonstrations in Nevada to test O2DieselTM
in non-tactical military equipment, and to test it in California in a fleet
      of
      refuse trucks. Other programs underway include completing the protocols to
      allow
      O2DieselTM to be classified as a Diesel Emissions Control Strategy fuel by the
      California Air Resources Board. Still other tests will include using O2DieselTM
      in large mining equipment as well as seeking to obtain a military procurement
      specification for the fuel. In January 2006, we initiated a project to develop
      a
      fuel that would meet EPA’s alternative fuel requirements for the military. Based
      on the government funding in place, we believe that approximately 80% of the
      costs to conduct these tests may be funded by appropriations from the U.S.
      Departments of Energy and Defense. All of these test procedures are complicated
      and may take considerable time to complete. At this point, we are at an early
      stage so that it is not possible to predict when this work will be completed
      or
      if we will obtain the desired results once it is completed.





We
      will
      also continue to devote considerable time and resources to the design and
      development of flame arrestor technology. We have found that this is more labor
      intensive and time consuming rather than requiring large outlays of capital.
      Most of the design work is being performed by our own personnel and consultants
      with the actual fabrication work contracted out to specialized manufacturers.





We
      are
      also working to refine our additive formulation in order to reduce its cost
      and
      increase its performance. We expect this work to continue in 2006.





In
      2006,
      we anticipate spending approximately $20,000 for various fuel and vehicle tests
      in Brazil.





9





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





**Employees**





As
      of
      June 30, 2006, O2Diesel has twenty-one full-time employees of which seventeen
      are in the U.S., three are in Brazil and one is in Europe. We have no part-time
      employees. Currently, we rely extensively on consultants to assist us with
      business development, commercializing our technology and to provide help in
      key
      technical areas. At present, we use eight consultants; three in marketing;
      one
      for investor relations; one field technician; one laboratory technician; one
      chemist and one in regulatory affairs.





We
      will
      add new personnel in 2006 based on the pace of our commercialization. Under
      our
      business plan, we do not see the need to add employees in the U.S. or Brazil,
      but we do plan to add technical positions for our European market testing and
      development in 2006. We anticipate continuing to employ eight consultants
      serving in most of the same capacities in 2006.





**Subsequent
      Events**





The
      Company’s Annual Meeting of shareholders was held on July 6, 2006 in Newark,
      Delaware. Of the 72,465,415 shares of common stock outstanding as of the record
      date of May 30, 2006, 48,081,289 shares, or 66.4% of the Company’s capital
      stock, were present or represented by proxy at the meeting, constituting a
      quorum.





The
      following proposals were approved by the shareholders:





1.
            Elect
                Mr. David L. Koontz, Mr. Gerson Santos-Leon and Mr. Jeffrey L. Cornish
                as
                Class B directors to hold office until the 2009 annual meeting of
                stockholders or until their respective successors are duly elected
                and
                qualified,





2.
            Ratify
                and approve the issuance of shares of Common Stock in connection
                with a
                private placement of Common Stock to accredited investors to the
                extent
                that such issuance would require shareholder approval under the rules
                of
                AMEX;





3.
            Ratify
                the appointment of Mayer Hoffman McCann P.C. to serve as the Company’s
                independent registered public accounting firm for the fiscal year
                ending
                December 31, 2006;





4.
            Approve
                an amendment to increase the number of shares authorized under the
                O2Diesel Corporation 2004 Stock Incentive Plan;
                and





5.
            Approve
                an amendment to the Company’s Certificate of Incorporation to increase the
                number of shares authorized.





At
      a
      subsequent meeting of the Board on July 6, 2006, the Board voted to grant
      1,550,000 options to employees, consultants and a director, which was announced
      in a Form 8-K filed on July 12, 2006. The Company also approved the Form of
      Incentive Option Agreement for options granted to officers, directors and
      employees, which was filed in a Form 8-K/A filed on July 28, 2006.





On
      July
      17, 2006, the Company received a letter from the AMEX indicating that the
      Company has regained compliance with AMEX listing requirements.





**ITEM
      3. CONTROLS AND PROCEDURES.**





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





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





**PART
      II. OTHER INFORMATION**





**ITEM
      1. LEGAL PROCEEDINGS.**





None.





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





**Changes
      to Common Stock**





Pursuant
      to the $2.0 million Private Placement, the Company received qualified
      subscriptions for 2,803,428 shares of its common stock at a price of $0.70
      per
      share, for total proceeds of $1,962,400, before payment of an 8% commission
      and
      other expenses,which together totaled $170,385. An initial closing for the
      $2.0 million Private Placement was held on March 17, 2005 for
      1,915,143 shares, which were issued on April 28, 2005. A final closing for
      the remaining 888,285 shares was held May 20, 2005. Pursuant to the
      $3.0 million Private Placement, the Company received subscriptions for
      4,712,553 shares of its common stock at $0.70 per share, for total proceeds
      of
      $3,298,787, before payment of a commission and other expenses, which together
      totaled $257,610. On June 10, 2005 an initial closing for the
      $3.0 million Private Placement was held for 4,583,973 shares of common
      stock. A final closing for the remaining 128,580 shares was held on
      August 9, 2005.





Subscribers
      to the $2.0 million and $3.0 million Private Placements received for
      each two shares of common stock purchased one warrant to purchase one additional
      share of common stock. The warrant expires twenty-four months following the
      closing of each Private Placement. Each warrant is exercisable at a price of
      $0.70 per share during the first twelve months following the close of each
      Private Placement, or at an exercise price of $1.05 per share in the second
      twelve months following the close of each Private Placement.





Pursuant
      to the $2.3 million Private Placement, the Company received a subscription
      for 3,228,070 shares of its common stock at $0.7125 per share, for total
      proceeds of $2,300,000 before payment of an 8% commission, all of which had
      been
      paid into an escrow account as of September 28, 2005. The Company announced
      the agreement and receipt of funds on October 4, 2005, received approval
      from the AMEX to list the shares and warrants on October 21, 2005, issued a
      certificate for the underlying shares on October 5, 2005, announced the
      closing on October 24, 2005 and funds were received on October 26,
      2005.





Pursuant
      to the $3.6 million Private Placement, the Company received a subscription
      for 6,419,840 shares of its common stock at $0.564 per share, for total proceeds
      of 3,000,000€, or approximately $3.6 million USD. The Company announced the
      agreement on October 28, 2005, received approval from the AMEX to list the
      shares and warrants on December 5, 2005, issued a certificate for the
      underlying shares on November 9, 2005 and announced the closing and
      received the funds on December 16, 2005.





Pursuant
      to the $4.0 million Private Placement, the Company received a subscription
      for
      5,333,333 shares of common stock at a purchase price of $0.75 per share for
      total proceeds of $4,000,000 before payment of expenses of $8,926. As part
      of
      this sale, the Company also issued warrants to purchase 2,666,667 shares of
      common stock at an exercise price of $.825 per share during the period of six
      months to forty-two months subsequent to issuance. The warrants expire forty-two
      months after the date of issuance. A closing was held on April 27, 2006.





Pursuant
      to the $2.5 million Private Placement, the Company received a subscription
      for
      3,333,333 shares of common stock at a purchase price of $0.75 per share for
      total proceeds of $2,500,000 before payment of a 9% commission and expenses
      totaling $233,925. As part of this sale, the Company also issued warrants to
      purchase 1,666,667 shares of common stock at an exercise price of $.825 per
      share during the period of six months to forty-two months subsequent to
      issuance. The warrants expire forty-two months after the date of issuance.
      A
      closing was held on April 27, 2006.





10





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





For
      both
      the $4.0 million and the $2.5 million Private Placements, the purchase price
      represented a discount of approximately 10% in comparison to the prevailing
      market price of the Company’s Common Stock during the period of negotiations for
      these private placements.





Subsequent
      to entering into the $4.0 million and the $2.5 million Private Placements,
      the
      Company entered into an identical amendment to each agreement which (i) modified
      the amount of liquidated damages to a maximum of 8% of the purchase price and
      (ii) added that shareholder approval will be obtained prior to the Company
      issuing the shares of common stock issuable upon exercise of the warrants.
      There
      were no other changes to either agreement.





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




There
        was
        no underwriter involved in either the $2.0 million, $3.0 million,
        $2.3 million, $3.6 million, $4.0 million and $2.5 million Private
        Placements. Sales of common stock under each of these Private Placements
        were
        exempt from registration pursuant to Section 4(2) of the Securities Act of
        1933, as amended (“Securities Act”), and Regulation D promulgated under the
        Securities Act.





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





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





Not
      applicable.





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





None





**ITEM
      5. OTHER INFORMATION.**





None





11





O2Diesel
      Corporation


(A
      Development Stage Company)


June
      30,
      2006





**ITEM
      6. EXHIBITS AND REPORTS ON FORM 8-K.**





The
      following exhibits are filed herewith.




ExhibitNumber
            
            Description3.1
            
            Certificate
                of Amendment, amending the Certificate of Incorporation
                (1)10.1
            
            Common
                Stock and Warrant Purchase Agreement for $4.0 million Private
                Placement (2)10.2
            
            Form
                of Warrant for $4.0 million Private Placement (2)10.3
            
            Amendment
                No. 1 to Common Stock and Warrant Purchase Agreement for $4.0 million
                Private Placement (3)10.4
            
            Common
                Stock and Warrant Purchase Agreement for $2.5 million Private
                Placement (2)10.5
            
            Form
                of Warrant for $2.5 million Private Placement (2)10.6
            
            Amendment
                No. 1 to Common Stock and Warrant Purchase Agreement for $2.5 million
                Private Placement (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(1)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(1)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(1)





(1)
            Filed
              herewith.(2)
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                April 20, 2006, and incorporated herein by
                reference.(3)
            Previously
                filed as an exhibit to the Company’s current report on Form 8-K on
                April 27, 2006, and incorporated herein by
                reference.




**12. SIGNATURES**





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


O2DIESEL
                CORPORATION
              (Registrant)Date:
                August 14, 2006
            By:
            /s/
                Alan RaeAlan
                RaeChief
                Executive Officer
              (Principal
                Executive Officer)


Date:
                August 14, 2006
            By:
            /s/
                David H. ShipmanDavid
                H. ShipmanChief
                Financial Officer
              (Principal
                Financial and Accounting
                Officer)






12