**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**




**WASHINGTON,
      DC 20549**




**FORM 10-Q**




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




**FOR
      THE QUARTERLY PERIOD ENDED June 30, 2008**




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
            
            91-2023525(State
                or Other
              Jurisdiction
                of Incorporation)
            
            (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 x No o




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




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




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


Yes o No x




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 14, 2008, the registrant had 88,490,174 shares of Common
      Stock,


$0.0001
      par value per share, issued and outstanding





O2DIESEL
      CORPORATION


FOR
      THE
      QUARTER ENDED JUNE 30, 2008


INDEX
      TO
      FORM 10-Q





PART I
                FINANCIAL INFORMATIONItem 1.
                Financial Statements
            F-2Item 2.
                Management’s Discussion and Analysis or Results of
                Operation
            1Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            12Item 4.
                Controls and Procedures
            12PART II
                OTHER INFORMATIONItem 1.
                Legal Proceedings
            13Item
                1A Risk Factors
            13Item 2.
                Unregistered Sales of Equity Securities and Use of
                Proceeds
            13Item 3.
                Defaults Upon Senior Securities
            13Item 4.
                Submission of Matters to a Vote of Security Holders
            13Item 5.
                Other Information
            13Item 6.
                Exhibits
            14Signatures
            14




NOTE
      REGARDING FORWARD LOOKING STATEMENTS




This
      quarterly report on Form 10-Q 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.





**02Diesel
      Corporation**


**(A
      Development Stage Company)**




**Consolidated
      Balance Sheets**




**June
      30, 2008 and December 31, 2007**


**(Unaudited)**





**June
                30,**
              **2008**
            
            **December
                31,**
              **2007****ASSETS****CURRENT
                ASSETS**Cash
            
            $
            163,511
            
            $
            581,645Restricted
                cash
            
            
            214,705
            
            
            2,333,959Accounts
                receivable
            
            
            1,645
            
            
            115,536Other
                receivables
            
            
            247,966
            
            
            192,619Unbilled
                appropriations receivable
            
            
            -
            
            
            145,576Inventory
            
            
            166,828
            
            
            174,447Prepaid
                expenses, parts and deposits
            
            
            174,132
            
            
            209,428Total
                current assets
            
            
            968,788
            
            
            3,753,210**FURNITURE
                AND EQUIPMENT**Office
                furniture and equipment
            
            
            287,045
            
            
            268,828Fuel
                and test equipment
            
            
            358,880
            
            
            382,971645,926
            
            
            651,799Less
                accumulated depreciation
            
            
            (304,276
            )
            
            (283,742
            )341,649
            
            
            368,057**TOTAL
                ASSETS**
            
            **$**
            **1,310,438**
            
            **$**
            **4,121,267****LIABILITIES
                AND STOCKHOLDERS' EQUITY (DEFICIT)****CURRENT
                LIABILITIES**Accounts
                payable
            
            $
            1,497,788
            
            $
            1,774,248Accrued
                expenses
            
            
            320,455
            
            
            568,442Deferred
                grants
            
            
            589,941
            
            
            475,980Deferred
                marketing program
            
            
            -
            
            
            86,333Total
                current liabilities
            
            
            2,408,184
            
            
            2,905,003**TOTAL
                LIABILITIES**
            
            
            **2,408,184**
            
            
            **2,905,003****STOCKHOLDERS'
                EQUITY (DEFICIT)**Preferred
                stock: par value of $0.0001; 20,000,000 shares authorized; none issued
                and
                outstanding
            
            
            -
            
            
            -Common
                stock: par value of $0.0001; 135,000,000 shares authorized; 88,051,752
                and
                86,666,837 issued and outstanding at June 30, 2008 and December 31,
                2007,
                respectively
            
            
            8,805
            
            
            8,667Additional
                paid-in capital
            
            
            45,575,714
            
            
            45,123,009Unearned
                compensation
            
            
            (2,932
            )
            
            (14,668
            )Accumulated
                other comprehensive income
            
            
            35,714
            
            
            12,088Deficit
                accumulated during the development stage
            
            
            (46,715,047
            )
            
            (43,912,832
            )Total
                stockholders' equity (deficit)
            
            
            (1,097,746
            )
            
            1,216,264**TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)**
            
            **$**
            **1,310,438**
            
            **$**
            **4,121,267**





*See
      Notes to Consolidated Financial Statements*


F-2


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**




**CONSOLIDATED
      STATEMENTS OF OPERATIONS**




**For
      the three and six months ended June 30, 2008 and 2007 and
      the**


**Period
      from October 14, 2000 (inception) through June 30,
      2008**


**(Unaudited)**


**October
                  14, 2000****(inception)****Three
                  Months Ended**
              
              
              
              **Six
                  Months Ended**
              
              **through****6/30/08**
              
              **6/30/07**
              
              
              
              **6/30/08**
              
              **6/30/07**
              
              **June
                  30, 2008**$
              6,579
              
              $
              15,035
              
              Additive
                  related sales
              
              $
              19,864
              
              $
              180,998
              
              $
              795,276-
              
              
              3,750
              
              Sponsorship
                  income
              
              
              -
              
              
              19,500
              
              
              169,2486,579
              
              
              18,785
              
              
              
              
              19,864
              
              
              200,498
              
              
              964,524**Expenses:**14,273
              
              
              14,130
              
              Cost
                  of goods sold
              
              
              22,499
              
              
              145,511
              
              
              598,0582,258
              
              
              -
              
              ProEco
                  operating expenses
              
              
              17,258
              
              
              -
              
              
              417,931176,169
              
              
              379,429
              
              Selling
                  and marketing
              
              
              426,662
              
              
              705,638
              
              
              9,692,62737,595
              
              
              26,550
              
              Product
                  testing and government grants, net
              
              
              71,553
              
              
              189,665
              
              
              1,671,1661,072,386
              
              
              1,715,870
              
              General
                  and administrative
              
              
              2,385,871
              
              
              3,749,145
              
              
              35,473,3011,302,681
              
              
              2,135,979
              
              **Total
                  operating expense**
              
              
              2,923,843
              
              
              4,789,959
              
              
              47,853,083**(1,296,102**
              **)**
              
              **(2,117,194**
              **)**
              **Operating
                  loss**
              
              
              **(2,903,979**
              **)**
              
              **(4,589,461**
              **)**
              
              **(46,888,559**
              **)****Other
                  income (expense):**(2,630
              )
              
              (3,053
              )
              Interest
                  expense
              
              
              (4,860
              )
              
              (4,906
              )
              
              (137,725
              )588
              
              
              5,704
              
              Interest
                  income
              
              
              1,820
              
              
              28,094
              
              
              236,418(20,813
              )
              
              34,232
              
              Foreign
                  currency gain/(loss), net
              
              
              100,164
              
              
              81,538
              
              
              905,608-
              
              
              -
              
              Loss
                  on impairment of construction in progress
              
              
              -
              
              
              -
              
              
              (1,288,614
              )7,498
              
              
              (280
              )
              Other
                  (expense)/income, net
              
              
              4,640
              
              
              (390
              )
              
              312,183(15,357
              )
              
              36,603
              
              **Total
                  other income (expense)**
              
              
              101,764
              
              
              104,336
              
              
              27,870(1,311,459
              )
              
              (2,080,591
              )
              **Loss
                  before benefit for income taxes**
              
              (2,802,215
              )
              
              (4,485,125
              )
              
              (46,860,689
              )-
              
              
              -
              
              Benefit
                  for income taxes
              
              
              -
              
              
              -
              
              
              145,642**(1,311,459**
              **)**
              
              **(2,080,591**
              **)**
              **Net
                  loss**
              
              
              **(2,802,215**
              **)**
              
              **(4,485,125**
              **)**
              
              **(46,715,047**
              **)****-**
              
              
              **-**
              
              **Deemed
                  dividend to preferred stockholders**
              
              
              **-**
              
              
              **-**
              
              
              (6,200,005
              )**$**
              **(1,311,459**
              **)**
              **$**
              **(2,080,591**
              **)**
              **Net
                  loss allocable to common stockholders**
              
              **$**
              **(2,802,215**
              **)**
              **$**
              **(4,485,125**
              **)**
              **$**
              **(52,915,052**
              **)**$
                  (0.02
              )
              $
              (0.03
              )
              Net
                  loss per common share
                (basic
                  and diluted)
              
              $
              (0.03
              )
              $
              (0.06
              )
              $
              (1.12
              )87,238,432
              
              
              75,642,046
              
              Weighted
                  average shares of common stock outstanding
              
              
              87,927,472
              
              
              75,504,260
              
              
              64,492,476-
              
              
              -
              
              Recapitalization
                    resulting from the AAE Technologies International PLC
                    acquisition
              
              
              -
              
              
              -
              
              
              (17,085,025
              )87,238,432
              
              
              75,642,046
              
              Weighted
                  average shares of common stock outstanding - giving effect to the
                  recapitalization
              
              
              87,927,472
              
              
              75,504,260
              
              
              47,407,451




*See
      Notes to Consolidated Financial Statements*


F-3


**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**





**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through June 30, 2008**


**(Unaudited)**




**Preferred Stock**
            
            **Common Stock**
            
            **Unearned**
            
            **Common**
            
            **Additional****Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **Compensation**
            
            **Stock**
                **Subscribed**
            
            **Paid-In**
                **Capital**Balance
                at October 14, 2000
              (Inception)Common
                stock issued in exchang for interest in wholly owned
                subsidiaries
            
            
            —
            
            $
            —
            
            
            43,008,772
            
            $
            430,088
            
            $
            —
            
            $
            —
            
            $
            3,603,415Net
                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
            
            
            11,745,765





*See
      Notes to Consolidated Financial Statements*


F-4




**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**





**October 14,
      2000 (inception) through June 30, 2008  (Continued)**


**(Unaudited)**





****
            
            **Preferred Stock**
            
            **Common Stock**
            
            **Unearned**
            
            **Common**
            
            **Additional****Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **Compensation**
            
            **Stock**
                **Subscribed**
            
            **Paid-In**
                **Capital**Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Foreign
                currency translation adjustment
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Comprehensive
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Common
                stock issued at $1.50 per share on various dates in 2004
            
            
            —
            
            
            —
            
            
            1,070,451
            
            
            107
            
            
            —
            
            
            (1,132,350
            )
            
            1,535,770Preferred
                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 in 2005
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            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 in 2006
            
            
            —
            
            
            —
            
            
            56,250
            
            
            6
            
            
            —
            
            
            —
            
            
            50,994Conversion
                of preferred stock into common stock on various dates in
                2006
            
            
            (1,550,000
            )
            
            (155
            )
            
            15,500,000
            
            
            1,550
            
            
            —
            
            
            —
            
            
            (1,395
            )Common
                stock issued at $0.75 per share in 2006
            
            
            —
            
            
            —
            
            
            8,666,666
            
            
            867
            
            
            —
            
            
            —
            
            
            6,256,282Common
                stock issued at $0.729 per share in 2006
            
            
            —
            
            
            —
            
            
            1,371,742
            
            
            138
            
            
            —
            
            
            —
            
            
            979,367Fair
                value of unvested stock options upon adoption of
                SFAS 123(R)
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (376,031
            )
            
            —
            
            
            376,031Amortization
                of unearned compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            250,890
            
            
            —
            
            
            —Fair
                value of stock options issued in 2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,476,684Balance
                at December 31, 2006
            
            
            —
            
            
            —
            
            
            75,125,014
            
            
            7,513
            
            
            (125,141
            )
            
            —
            
            
            40,076,305




*See
      Notes to Consolidated Financial Statements*


F-5





**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through June 30, 2008 (Continued)**


**(Unaudited)**




**Preferred Stock**
            
            **Common Stock**
            
            **Unearned**
            
            **Common**
            
            **Additional****Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **Compensation**
            
            **Stock**
              **Subscribed**
            
            **Paid-In**
                **Capital**Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Foreign
                currency translation adjustment
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Comprehensive
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Common
                stock issued to employee
            
            
            —
            
            
            —
            
            
            333,333
            
            
            33
            
            
            —
            
            
            —
            
            
            273,266Fair
                value of unearned shares related to ommitment shares
            
            
            —
            
            
            —
            
            
            805,987
            
            
            80
            
            
            —
            
            
            —
            
            
            668,889Unearned
                common stock issued for commitment shares
            
            
            —
            
            
            —
            
            
            (465,170
            )
            
            (47
            )
            
            —
            
            
            —
            
            
            (386,044
            )Fusion
                shares issued at various prices in 2007
            
            
            —
            
            
            —
            
            
            970,994
            
            
            97
            
            
            —
            
            
            —
            
            
            499,903Common
                stock issued for consulting services
            
            
            —
            
            
            —
            
            
            540,000
            
            
            54
            
            
            —
            
            
            —
            
            
            263,446Common
                stock issued at $0.405 per share in 2007
            
            
            —
            
            
            —
            
            
            2,993,346
            
            
            299
            
            
            —
            
            
            —
            
            
            1,109,944Repurchase
                of shares
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Retirement
                of repurchased shares
            
            
            —
            
            
            —
            
            
            (100,000
            )
            
            (10
            )
            
            —
            
            
            —
            
            
            (40,090
            )Common
                stock issued at $0.417 per share in 2007
            
            
            —
            
            
            —
            
            
            3,130,000
            
            
            313
            
            
            —
            
            
            —
            
            
            1,194,821Common
                stock issued at $0.375 per share in 2007
            
            
            —
            
            
            —
            
            
            3,333,333
            
            
            334
            
            
            —
            
            
            —
            
            
            1,249,666Amortization
                of unearned compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            110,473
            
            
            —
            
            
            (24,727
            )Fair
                value of stock options issued in 2006 and 2007
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            237,631Balance
                at December 31, 2007
            
            
            —
            
            
            —
            
            
            86,666,837
            
            
            8,667
            
            
            (14,668
            )
            
            —
            
            
            45,123,009Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Foreign
                currency translation adjustment
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Comprehensive
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Unearned
                common stock issued for commitment shares
            
            
            —
            
            
            —
            
            
            193,414
            
            
            19
            
            
            —
            
            
            —
            
            
            160,514Common
                stock issued for consulting services
            
            
            —
            
            
            —
            
            
            1,191,501
            
            
            119
            
            
            —
            
            
            —
            
            
            256,131Amortization
                of unearned compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            11,736
            
            
            —
            
            
            —Fair
                value of stock options issued in 2006 and 2007
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            36,060Balance
                at June 30, 2008
            
            
            —
            
            $
            —
            
            
            88,051,752
            
            $
            8,805
            
            $
            (2,932
            )
            $
            —
            
            $
            45,575,714




*See
      Notes to Consolidated Financial Statements*


F-6





**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through June 30, 2008 (Continued)**


**(Unaudited** **)**




**Common**
              **Stock**
              **Subscriptions**
              **Receivable**
            
            **Accumulated**
              **Other**
              **Comprehensive**
              **Income (Loss)**
            
            **Treasury**
              **Stock**
            
            **Deficit**
              **Accumulated**
              **During the**
              **Development**
              **Stage**
            
            **Total**
              **Stockholders’**
              **Equity**
              **(Deficit)**Balance at
                October 14, 2000 (Inception)Common
                stock issued in exchange for interest in wholly owned
                subsidiaries
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            (4,138,684
            )
            $
            (105,181
            )Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (1,406,709
            )
            
            (1,406,709
            )Foreign
                currency translation adjustment
            
            
            —
            
            
            (4,476
            )
            
            —
            
            
            —
            
            
            (4,476
            )Comprehensive
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (1,411,185
            )Common
                stock issued on various dates during 2001
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,509,841Balance
                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
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,218,304Recapitalization
                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
            )
            
            140,776




*See
      Notes to Consolidated Financial Statements*


F-7





**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through June 30, 2008 (Continued)**


**(Unaudited)**




**Common**
              **Stock**
              **Subscriptions**
              **Receivable**
            
            **Accumulated**
              **Other**
              **Comprehensive**
              **Income (Loss)**
            
            **Treasury**
              **Stock**
            
            **Deficit**
              **Accumulated**
              **During the**
              **Development**
              **Stage**
            
            **Total**
              **Stockholders’**
              **Equity**
              **(Deficit)**Net loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (6,852,165
            )
            
            (6,852,165
            )Foreign
                currency translation adjustment
            
            
            —
            
            
            2,329
            
            
            —
            
            
            —
            
            
            2,329Comprehensive
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (6,849,836
            )Common
                stock issued for consulting services in 2005
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            63,100Warrants
                issued for consulting services in 2005
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            135,000Common
                stock issued at $0.70 per share on various dates in 2005
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            4,833,191Common
                stock issued at $0.7125 per share on various dates in 2005
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            2,090,500Common
                stock issued at $0.564 per share on various dates in 2005
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            3,600,300Balance
                at December 31, 2005
            
            
            —
            
            
            6,011
            
            
            —
            
            
            (25,478,285
            )
            
            4,013,031Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (7,608,155
            )
            
            (7,608,155
            )Foreign
                currency translation adjustment
            
            
            —
            
            
            (10,392
            )
            
            —
            
            
            —
            
            
            (10,392
            )Comprehensive
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (7,618,547
            )Common
                stock issued via exercise of warrants on various dates in
                2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,458,144Common
                stock issued for consulting services in 2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            51,000Conversion
                of preferred stock into common stock on various dates in
                2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Common
                stock issued at $0.75 per share in 2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            6,257,149Common
                stock issued at $0.729 per share in 2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            979,505Fair
                value of unvested stock options upon adoption of
                SFAS 123(R)
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Amortization
                of unearned compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            250,890Fair
                value of stock options issued in 2006
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,476,684Balance
                at December 31, 2006
            
            
            —
            
            
            (4,381
            )
            
            —
            
            
            (33,086,440
            )
            
            6,867,856




*See
      Notes to Consolidated Financial Statements*


F-8





**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**




**October 14,
      2000 (inception) through June 30, 2008 (Continued)**


**(Unaudited)**


**Common**
                **Stock**
                **Subscriptions**
                **Receivable**
              
              **Accumulated**
                **Other**
                **Comprehensive**
                **Income (Loss)**
              
              **Treasury**
                **Stock**
              
              **Deficit**
                **Accumulated**
                **During the**
                **Development**
                **Stage**
              
              **Total**
                **Stockholders’**
                **Equity**
                **(Deficit)**Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              (10,826,392
              )
              
              (10,826,392
              )Foreign
                  currency translation adjustment
              
              
              —
              
              
              16,469
              
              
              —
              
              
              —
              
              
              16,469Comprehensive
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (10,809,923
              )Common
                  stock issued to employee
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              273,299Fair
                  value of unearned shares related to commitment shares
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              668,969Unearned
                  common stock issued for commitment shares
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (386,091
              )Fusion
                  shares issued at various prices in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              500,000Common
                  stock issued for consulting services
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              263,500Common
                  stock issued at $0.405 per share in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,110,243Repurchase
                  of shares
              
              
              —
              
              
              —
              
              
              (40,100
              )
              
              —
              
              
              (40,100
              )Retirement
                  of repurchased shares
              
              
              —
              
              
              —
              
              
              40,100
              
              
              —
              
              
              —Common
                  stock issued at $0.417 per share in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,195,134Common
                  stock issued at $0.375 per share in 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              1,250,000Amortization
                  of unearned compensation
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              85,746Fair
                  value of stock options issued in 2006 and 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              237,631Balance
                  at December 31, 2007
              
              
              —
              
              
              12,088
              
              
              —
              
              
              (43,912,832
              )
              
              1,216,264Net
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              (2,802,215
              )
              
              (2,802,215
              )Foreign
                  currency translation adjustment
              
              
              —
              
              
              23,626
              
              
              —
              
              
              —
              
              
              23,626Comprehensive
                  loss
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (2,778,589
              )Unearned
                  common stock issued for commitment shares
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              160,533Common
                  stock issued for consulting services
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              256,250Amortization
                  of unearned compensation
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              11,736Fair
                  value of stock options issued in 2006 and 2007
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              36,060Balance
                  at June 30, 2008
              
              $
              —
              
              $
              35,714
              
              $
              —
              
              $
              (46,715,047
              )
              $
              (1,097,746
              )




*See
      Notes to Consolidated Financial Statements*




F-9




**O2DIESEL
      CORPORATION**


**(A
      Development Stage Company)**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**For
      the six months ended June 30, 2008 and 2007 and the**


**Period
      from October 14, 2000 (inception) through June 30,
      2008**


**(Unaudited)**


**October 14, 2000****(inception)****Six Months Ended June 30,**
              
              **through****2008**
              
              **2007**
              
              **June 30, 2008****Cash
                  flows from operating activites**Net
                  loss
              
              **$**
              **(2,802,215**
              **)**
              **$**
              **(4,485,125**
              **)**
              **$**
              **(46,715,047**
              **)**Adjustments
                  to reconcile loss to net cash used in operating activites:Depreciation
              
              
              41,759
              
              
              44,015
              
              
              423,135Amortization
              
              
              -
              
              
              -
              
              
              7,786Write
                  off of patent
              
              
              -
              
              
              -
              
              
              337,329Write
                  off of obsolete inventory
              
              
              -
              
              
              -
              
              
              5,925(Gain)
                  loss on sale/disposal of furniture & equipment
              
              
              (4,664
              )
              
              -
              
              
              5,588Loss
                  on impairment of construction in progress
              
              
              -
              
              
              -
              
              
              1,288,614Non
                  cash contributions
              
              
              -
              
              
              -
              
              
              5,312Common
                  stock and warrants issued for consulting services
              
              
              256,250
              
              
              143,600
              
              
              773,850Common
                  stock issued to employee
              
              
              -
              
              
              136,650
              
              
              273,299Common
                  stock issued for commitment shares
              
              
              160,533
              
              
              122,326
              
              
              443,411Amortization
                  of unearned compensation
              
              
              47,796
              
              
              222,324
              
              
              2,098,747Changes
                  in operating assets and liabilites:Accounts
                  receivable
              
              
              113,891
              
              
              (47,573
              )
              
              (1,645
              )Other
                  receivables
              
              
              (55,347
              )
              
              (452,727
              )
              
              (247,966
              )Inventory,
                  prepaid expenses and other current assets
              
              
              188,491
              
              
              18,943
              
              
              (346,885
              )Accounts
                  payable
              
              
              (276,460
              )
              
              590,766
              
              
              1,497,788Accrued
                  expenses
              
              
              (247,987
              )
              
              (97,743
              )
              
              309,297Deferred
                  grants
              
              
              113,961
              
              
              333,640
              
              
              589,941Deferred
                  marketing program
              
              
              (86,333
              )
              
              (136,500
              )
              
              -Cash
                  flows used in operating activities
              
              
              **(2,550,326**
              **)**
              
              **(3,607,404**
              **)**
              
              **(39,251,522**
              **)****Cash
                  flows from investing activities**Restricted
                  cash
              
              
              2,119,254
              
              
              502,694
              
              
              (214,705
              )Purchase
                  of furniture and equipment
              
              
              (17,687
              )
              
              (10,495
              )
              
              (2,072,388
              )Proceeds
                  from sale of furniture & equipment
              
              
              7,000
              
              
              -
              
              
              20,150Purchase
                  of patent
              
              
              -
              
              
              -
              
              
              (345,115
              )Cash
                  flows provided by (used in) investing activities
              
              
              **2,108,567**
              
              
              **492,199**
              
              
              **(2,612,058**
              **)****Cash
                  flows from financing activities**Net
                  proceeds from issuance of preferred stock
              
              
              -
              
              
              -
              
              
              5,478,764Net
                  proceeds from private placement
              
              
              -
              
              
              -
              
              
              5,953,757Purchase
                  of treasury stock
              
              
              -
              
              
              -
              
              
              (40,100
              )Net
                  proceeds from issuance of common stock
              
              
              -
              
              
              500,000
              
              
              30,605,870Cash
                  flows provided by financing activities
              
              
              **-**
              
              
              **500,000**
              
              
              **41,998,291**Effect
                  of exchange rate changes on cash
              
              
              23,626
              
              
              9,812
              
              
              28,801**Net
                  (decrease) increase in cash**
              
              
              **(418,134**
              **)**
              
              **(2,605,393**
              **)**
              
              **163,511****Cash
                  at beginning of period**
              
              
              **581,645**
              
              
              **3,065,630**
              
              
              **-****Cash
                  at end of period**
              
              **$**
              **163,511**
              
              **$**
              **460,237**
              
              **$**
              **163,511**Cash
                  paid for interest
              
              $
              4,860
              
              $
              4,906
              
              $
              128,373Cash
                  paid for income taxes
              
              
              None
              
              
              None
              
              
              None




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


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




*See
      Notes to Consolidated Financial Statements*




F-10




**O2Diesel Corporation**  **(A Development
      Stage Company)**


**Notes
      to Consolidated Financial Statements**


**(Unaudited)**




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




***The
      Company***




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




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




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 Company has received approvals to list
      75,244,983 shares of the Company’s common stock so that the total number of
      shares approved for listing is now 121,763,881. Our shares began to trade on
      the
      Exchange on July 1, 2004.





On
      April 28, 2008 the Company announced that it began trading on the Pink
      Sheet Electronic Quotation Service under the trading symbol OTOD.PK. The
      Company’s shares then began to trade under the symbol OTOD.OB on or about May
      26, 2008.





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




**Basis
      of Presentation**




The
      Company’s unaudited consolidated financial statements for the three and six
      months ended June 30, 2008 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.  We have reclassified certain
      prior-period amounts to conform to the current period’s presentation.  If
      the Company were to continue to incur losses without additional funding and
      were
      to fail to continue as a going concern, then its assets and liabilities would
      be
      required to be stated on a liquidation basis which would differ significantly
      from the going concern basis.




At
      June
      30, 2008, the Company had negative working capital of $1,439,396, of which
      $214,705 was restricted in use to operational costs associated with developing
      markets in Europe, and had accumulated losses of $46,715,047.  At
      December 31, 2007, the Company had positive working capital of $848,207, of
      which $2,333,959 was restricted in use to operational costs associated with
      developing markets in Europe, and had accumulated losses of $43,912,832. 
The lack of adequate working capital and continuing losses create an uncertainty
      about the Company’s ability to continue as a going concern. The financial
      statements do not include any adjustments that might be necessary if the Company
      is unable to continue as a going concern.




Management
      has concluded that additional equity must be raised in 2008 in order for the
      Company to have sufficient cash to execute its business plan.




The
        consolidated financial statements in this report do not include any adjustments
        to reflect the anticipated private placements or the possible future effects
        on
        the recoverability and classification of assets or the amounts and
        classification of liabilities that may result should management be unsuccessful
        in obtaining financing on terms acceptable to the Company.
  From
        July 2003 through July 2008, the Company has raised approximately $38
        million for its operations.


F-11


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





**AMEX
      Delisting**




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




On
      July 27, 2007, the Company filed a plan with the Exchange describing the
      steps it planned to take to return to full compliance.  On
      September 13, 2007, the Company received a written notice from the AMEX
      indicating that AMEX had reviewed and accepted the Company’s plan to regain
      listing qualifications compliance.  With the acceptance of the plan, the
      Company would be able to continue its listing during the plan period pursuant
      to
      an extension granted until December 29, 2008.  The AMEX notice also
      advised the Company that, in addition to the previously disclosed deficiency
      with respect to Section 1003(a)(iii) of the AMEX Company Guide, it had
      triggered an additional deficiency with respect to Section 1003(a)(ii).





Under
      the
      terms of the notice from AMEX, the Company was to continue to provide AMEX
      staff
      with updates regarding initiatives set forth in its plan of compliance.  If
      the Company was not in compliance on December 29, 2008, or the Company did
      not make progress consistent with the plan during the interim period, the AMEX
      would likely initiate procedures to de-list the Company’s common stock. On
      February 7, 2008, the Company received notice from the staff of the AMEX
      that due to the deferral of the ProEco project, as described in Note 3, the
      Company was no longer demonstrating progress consistent with the plan and had
      determined to proceed with an application to the Securities and Exchange
      Commission to remove the common stock of the Company from listing and
      registration on AMEX. This action was taken because the Company is not in
      compliance with Section 1003(a)(ii) and (iii) of the AMEX Company
      Guide.




On
      February 12, 2008, the Company appealed the delisting determination by
      requesting an oral hearing to present its plan, its progress in achieving the
      plan and maintaining its AMEX listing. On April 4, 2008, the Company
      received notice from AMEX that it was not in compliance with
      Sections 1003(a)(i) and (iv) of the AMEX Company Guide. 
Subsequent to an oral hearing on April 15, 2008, the Company received
      notice on April 21, 2008 from AMEX indicating its determination to prohibit
      the continued listing of the Company’s common stock on the Exchange and to
      initiate delisting proceedings.





On
      April 28, 2008 the Company announced that it began trading on the Pink
      Sheet Electronic Quotation Service under the trading symbol OTOD.PK. The
      Company’s shares then began to trade under the symbol OTOD.OB on or about May
      26, 2008.




F-12


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**2.
      Summary of Significant Accounting Policies**




**Principles
      of Consolidation**




The
      consolidated financial statements include the accounts of the Company, its
      subsidiaries and all affiliated subsidiaries. All significant inter-company
      balances and transactions have been eliminated in consolidation. Based on
      Financial Accounting Standards Board (“FASB”) Interpretation No. 46R, “*Consolidation
      of Variable Interest Entities* ”
(“FIN
      46R”), the Company is the holder of the majority of the risks and rewards
      relating to ProEco Energy Company, Inc. (“ProEco”). As such, the Company is
      considered to be the “primary beneficiary” of ProEco, deemed to be a variable
      interest entity (“VIE”), and has included ProEco’s assets, liabilities and
      operating results in its consolidated financial statements for the three and
      six
      months ended June 30, 2008 and for the period October 14, 2000
      (inception) through June 30, 2008.




**Variable
      Interest Entity (VIE)**




In
      general, a VIE is a corporation, partnership, limited-liability corporation,
      trust or any other legal structure used to conduct activities or hold assets
      that either (i) has an insufficient amount of equity to carry out its
      principal activities without additional subordinated financial support;
      (ii) has a group of equity owners that are unable to make significant
      decisions about its activities; or (iii) has a group of equity owners that
      do not have the obligation to absorb losses or the right to receive returns
      generated by its operations. Based on these guidelines, the Company determined
      that ProEco is a VIE beginning with the third quarter of 2007. Prior to that
      period, activity with ProEco was not material.




**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, 2008
      and
      December 31, 2007, cash deposits exceeded federally insured limits which
      are generally $100,000 per financial institution.




**Restricted
      Cash**




On
      December 16, 2005, the Company completed a private placement of its common
      stock, whereby it received approximately $3.6 million which is restricted to
      operational costs associated with developing markets in Europe.  In 2008,
      the Company notified the investor in this private placement that it has
      temporarily utilized a portion of these funds for current non-European operating
      purposes.  The investor has acknowledged this temporary utilization with
      the expectation that these funds will be repaid.  The Company has used
      approximately $1.0 million of these funds (net of $159,000 in repayments)
      through August 14, 2008.  In addition to the $695,000 and $1.2 million
      temporarily utilized for non-European operating purposes during the three and
      six month periods ended June 30, 2008, respectively, restricted funds declined
      by approximately $615,000 and $957,000 for the same periods, net of foreign
      currency (losses) gains of approximately ($20,000) and $100,000 for the same
      periods, as a result of marketing expenditures 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, deferred
      marketing program accruals, and deferred grants approximate fair value because
      of their short-term nature.




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




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


F-13


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




**Inventories**




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




**Furniture,
      Equipment, Construction in Progress**  **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 to 20 years




Depreciation
      expense recorded in the accompanying Consolidated Statements of Operations
      was
      $22,420 and $44,015, respectively for the three and six months ended June 30,
      2007, and was $20,841, $41,759 and $423,135 respectively for the three and
      six
      months ended June 30, 2008 and for the period October 14, 2000
      (inception) through June 30, 2008.




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




The
      carrying values of intangible and 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.




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




**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 an
      important 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, 2008 and December 31, 2007, costs
      remaining to be amortized for CityHomeTM programs were recorded on the
      balance sheet as Deferred Marketing Program in the amount of $0 and $86,333,
      respectively. Within Selling and marketing expense, the Company
      recorded ($64,732) and ($63,585) in net expenses (income) for the
      CityHomeTM initiatives, in excess of sponsorship fees, during the three and
      six months ended June 30, 2008 and $69,334, $86,393 and $1,158,418 for the
      three
      and six months ended June 30, 2007 period October 14, 2000
      (inception) through June 30, 2008, respectively.




F-14


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




**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.




**Advertising
      Expenses**




Advertising
      costs are expensed as incurred. There were no advertising expenses for the
      three
      and six months ended June 30, 2008 and 2007 and $450,000 for the period
      October 14, 2000 (inception) to June 30, 2008.




**Research
      and Development Costs**




Research
      and development costs are expensed as incurred.




**Product
      Test and Demonstration Appropriations**




The
      Company receives appropriations from governmental agencies to fund certain
      of
      its research and development efforts. The Company evaluates the conditions
      of
      each appropriation and either increases revenue, decreases expenses or reduces
      the cost of fixed assets depending upon the attributes of the underlying grant.
      Appropriations activities are not recognized until there is reasonable assurance
      that the Company will comply with the conditions of the grant and that 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.
      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**




In
      December 2004, the FASB issued SFAS No. 123 (revised
      2004), *“Share-Based
      Payment”* (“SFAS 123(R)”), which replaces FASB Statement No. 123, *“Accounting
      for Stock-Based Compensation”* (“SFAS 123”) and supersedes Accounting Principles Board (“APB”) Opinion
      No. 25 (“APB 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 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 25 for
      certain options granted to non-employees of the Company based upon the intrinsic
      value. SFAS 123(R) requires all share-based payments, including grants
      of employee stock options, to be recognized in the financial statements based
      on
      their fair values beginning with the first interim period after
      December 15, 2005, with early adoption encouraged. The pro forma
      disclosures previously permitted under SFAS 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 123(R) using the modified prospective transition method. As a
      result, the Company’s net loss before taxes was $2,098,750 higher for the period
      October 14, 2000 (inception) through June 30, 2008, than if it had
      continued to account for share-based compensation under
      APB 25.




Stock
      options generally vest over three years and expire ten 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 of Directors 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.  During the three and six months ended June 30, 2008 and 2007, no
      additional options were granted and, in the first quarter of 2008, 200,000
      options expired unexercised.


F-15


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




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 were
      as
      follows:




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








*
      Depending on the date of grant.




**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.




In
      June,
      2006, the FASB issued Interpretation No. 48, *“Accounting
      for Uncertainty in Income Taxes”* (FIN 48) which was effective for fiscal years beginning after
      December 15, 2006. This interpretation clarified the accounting for
      uncertainty in income taxes recognized in accordance with SFAS 109.
      Specifically, FIN 48 clarifies the application of SFAS 109 by defining
      a criterion that an individual tax position must meet for any part of the
      benefit of that position to be recognized in an enterprise’s financial
      statements. Additionally, FIN 48 provides guidance on measurement,
      derecognition, classification, interest and penalties, accounting in interim
      periods of income taxes, as well as the required disclosure and transition.
      This
      interpretation was effective for fiscal years beginning after December 15,
      2006. Effective January 1, 2007, the Company adopted FIN 48 and has
      determined that such adoption has not had a significant effect on the Company’s
      consolidated financial position and results of operations.




**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 period-end exchange rates, and the
      income and expenses have been translated using the weighted average of
      historical exchange rates during the reporting period. The adjustments resulting
      from translation have been recorded separately in stockholders’ equity (deficit)
      as “accumulated other comprehensive income” and are not included in determining
      the consolidated net loss. As of June 30, 2008 and December 31, 2007,
      accumulated other comprehensive income included $35,714 and $12,088,
      respectively, of cumulative income from foreign currency
      translation.




The
      Company began operations in Brazil in March of 2004 by establishing a
      75%-owned subsidiary. The Brazilian subsidiary recognized zero revenue for
      the
      three and six months ended June 30, 2008 and 2007 and $7,682 for the period
      October 14, 2000 (inception) through June 30, 2008. Brazil also had total
      assets less current liabilities (exclusive of intercompany amounts eliminated
      in
      consolidation) of $98,022 and $95,201 at June 30, 2008 and December 31,
      2007, respectively. Transactions in Brazil are denominated in, and the
      functional currency is, the Brazilian Real. Accordingly, no Brazilian operations
      currency exchange rate gains or losses are recorded in the accompanying
      consolidated statement of operations. At June 30, 2008 and December 31,
      2007, the Brazilian operation had aggregate losses of $2,267,487 and $2,038,986,
      respectively. 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-16


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




On
      December 31, 2004, the Company ceased operations at two of its wholly-owned
      subsidiaries 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.
      Since that date, these subsidiaries incurred no activity and therefore had
      no
      profit or loss.




The
      company began operations in Spain in April of 2006 by establishing a 100%
      subsidiary. The Spanish subsidiary recognized $0 and $0 of revenue for the
      three and six months ended June 30, 2007 and $1,936, $4,427, and $16,603
      of revenue for the three and six months ended June 30, 2008 and for the
      period of April 2006 through June 30, 2008, respectively. At June 30, 2008
      and December 31, 2007, the Spanish subsidiary had total assets less current
      liabilities (exclusive of intercompany amounts eliminated in consolidation)
      of
      $211,185 and $275,678, respectively. Transactions in Spain are denominated
      in,
      and the functional currency is, the Euro. At June 30, 2008 and December 31,
      2007, the Spanish operation had aggregate losses of $2,753,120 and
      $1,933,878.




The
      Company expanded its operations in Ireland in August 2007 by establishing a
      100% owned subsidiary. At June 30, 2008, this subsidiary had not been an active
      company.




**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,
      2008 and December 31, 2007 and the results of operations and cash flows
      presented herein for the three and six month periods ended June 30, 2008 and
      2007 and from inception (October 14, 2000) through June 30, 2008 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, 2008. 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, 2007 previously filed with the
      Securities and Exchange Commission (the "SEC") on March 31, 2008 and the Form
      10-KSB/A previously filed with the SEC on August 6, 2008.




**3.
      ProEco Transaction**




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




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




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




F-17


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**3.
      ProEco Transaction (continued)**




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




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




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




Pursuant
      to the terms of the letter of intent for the Agreement, the Company agreed
      to
      enter into a secured loan agreement with ProEco for the purposes of financing
      the purchase options for the land to be used for the Ethanol Plant and certain
      engineering and permitting work required for the closing of the ProEco share
      exchange. The annual interest rate on the loan is 7% and the maturity date
      of
      the loan was December 15, 2007.




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




Based
      on
      FIN 46R, the Company is the holder of the majority of the risks and rewards
      relating to ProEco. As such, the Company is considered to be the “primary
      beneficiary” of ProEco which is deemed to be a VIE. (In general, a VIE is a
      corporation, partnership, limited-liability corporation, trust or any other
      legal structure used to conduct activities or hold assets that either
      (i) has an insufficient amount of equity to carry out its principal
      activities without additional subordinated financial support; (ii) has a
      group of equity owners that are unable to make significant decisions about
      its
      activities; or (iii) has a group of equity owners that do not have the
      obligation to absorb losses or the right to receive returns generated by its
      operations.) Based on these guidelines, the Company determined that ProEco
      was a
      VIE beginning with the third quarter of 2007 and has included ProEco’s assets,
      liabilities and operating results in its consolidated financial statements.
      Prior to that period, activity with ProEco was not material.




The
      following table summarizes the significant assets and liabilities of ProEco
      as
      of June 30, 2008 and December 31, 2007:




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




Including
      a $1,288,614 impairment charge and after elimination of intercompany
      transactions, ProEco expenses of $2,258, $17,258 and $1,706,545 for the three
      and six months ended June 30, 2008 and the period October 14, 2000
      (inception) through June 30, 2008, respectively, are also reflected in the
      Company’s Consolidated Statements of Operations. There were no ProEco expenses
      recorded for the three and six months ended June 30, 2007.


F-18


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




**Energenics
      Transactions**




On
      October 17, 2007, the Company announced that it had entered into a private
      financing agreement and a joint venture transaction with Energenics Holdings
      Pte
      Ltd (“Energenics”) to provide funding and commercial support for the development
      of the Asian market. At that time, the parties entered into a Common Stock
      and
      Warrant Purchase Agreement (the “ *Agreement* ”)
      pursuant to which Energenics agreed to purchase 2,551,020 shares of the
      Company’s common stock in a private placement, for total proceeds of
      approximately $1.25 million. As part of the transaction, the Company agreed
      to
      issue a warrant to purchase 1,275,510 shares of common stock at an exercise
      price of $0.50 per share, which warrant would be issued upon the closing of
      the
      transactions contemplated by the Agreement and would become exercisable from
      the
      date that is six months following the date of issuance until October 17, 2012
      (“ *Investment
      Warrant* ”).





The
      parties also entered into a Shareholders Agreement, in which Energenics and
      the
      Company would jointly develop the market for O2DieselTM in Asia through O2Diesel
      Asia Limited (“O2Diesel Asia”). Energenics agreed to pay the Company $750,000
      for a fifty percent (50%) equity interest in O2Diesel Asia. The balance of
      the
      interest in O2Diesel Asia was to be held by O2Diesel Europe Limited,
      a wholly-owned subsidiary of the Company. Pursuant to the Supply and
      Distribution Agreement, dated September 15, 2006 (“ *Supply
      Agreement”* ),
      O2Diesel has supplied its additive to Energenics for the manufacture and
      distribution of O2DieselTM in the Asian Pacific and South Asia.





The
      parties also were to enter into a License agreement(“ *O2Diesel
      Asia License Agreement* ”),
      whereby O2Diesel Europe Limited (formerly AAE Technologies International Plc)
      would license to O2Diesel Asia certain patents and know-how that are required
      to
      make and sell O2DieselTM in the Territory in exchange for certain payments
      pursuant to the Shareholders Agreement. In addition, the Company was to enter
      into a similar License agreement (the “ *License Agreement* ”
and
      together with the O2Diesel Asia License Agreement, the “ *Licenses* ”),
      with
      O2Diesel Asia, pursuant to which the Company would pay to O2Diesel Asia a
      royalty based on sales of the Company’s product in the Territory.





As
      part
      of the transaction, upon the purchase of a certain quantity of O2D05 or the
      equivalent, the Company would also issue a warrant to purchase 1,500,000 shares
      of common stock at an exercise price of $0.50 per share, which warrant would
      be
      exercisable during the period from the date of issuance until October 17,
      2012 (“ *JV
      Warrant”)* .





Also,
      as
      part of the transaction, upon the achievement by Energenics of certain levels
      of
      additional purchases of O2D05 or the equivalent, the Company was to issue
      additional warrants to purchase up to an aggregate of 6,500,000 shares of common
      stock at a price per share equal to the lesser of $0.50 or 106% of the closing
      price per share (rounded to the nearest cent) of the Company’s common stock on
      the American Stock Exchange on the date such warrants are earned (“ *Market Development Warrants* ,” and,
      collectively with the Investment Warrant and the JV Warrant, the “ *Warrants* ”).
      The
      Market Development Warrants were to be exercisable from the date of issuance
      to
      October 17, 2012.





On
      December 10, 2007, the Company and Energenics entered into an amendment (the
      “ *Amendment* ”)
      to the
      Common Stock and Warrant Purchase Agreement, dated October 17, 2007. Pursuant
      to
      the Amendment, the Company agreed to increase the number of shares of common
      stock by 782,313 shares to 3,333,333 shares, which reduced the per share price
      from $0.49 to $0.375. The per share price of $0.375 represented 121% of the
      current market price on the American Stock Exchange the day prior to the signing
      of the Amendment. In addition, the Company agreed to issue an additional 391,157
      shares exercisable pursuant to the warrant associated with the Investment
      Warrant. In addition, the Company was to issue additional warrants (the
“ *Additional
      Warrants* ,”
and
      together with the Investment Warrant, the “ *Amended
      Warrants* ”)
      to
      purchase shares of common stock, upon the purchase of certain quantities of
      O2D05 or the equivalent. Pursuant to the Amendment, the exercise price per
      share
      for the shares associated with these Additional Warrants was also reduced to
      $0.375.




All
      other
      terms and conditions of the transaction remain as provided in the
      Agreement.





The
      common stock and the Warrants were to be issued to the accredited investor
      in a
      transaction that would be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act of 1933, as amended (the “Securities Act”), and/or Regulation
      D promulgated under the Securities Act.




F-19


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**





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





On
        June
        17, 2008, the Company entered into an Amending and Restating Agreement with
        Energenics to reflect the renegotiated terms of previously announced agreements
        to provide $2,000,000 of funding and commercial support to develop the Asian
        market for O2DieselTM, the Company’s ethanol diesel fuel blend.
 
 According
        to the terms of the Amending and Restating Agreement, the original Common
        Stock
        and Warrant Purchase Agreement dated October 17, 2007 and the subsequent
        Amendment are to be terminated and the previously issued shares of O2Diesel
        Corporation common stock are to be retired by the Company when the transaction
        closes. The original Shareholder’s Agreement between Energenics and the Company
        will be amended to reflect that Energenics agreed to pay the Company $1,250,000
        for an eighty percent (80%) equity interest in O2Diesel Asia. The balance
        of the
        interest in O2Diesel Asia is to be held by O2Diesel Europe Limited, a
        wholly-owned subsidiary of the Company. The existing Warrants (as amended),
        Licenses and Supply Agreement will remain unchanged.
 
 Under
        the
        terms of the Amending and Restating Agreement, the original shares of the
        Company’s common stock issued to Energenics (in escrow) are to be retired and
        $1,250,000 is to be paid for the 80% equity interest in O2Diesel Asia. In
        addition, the Company will enter into an agreement with Energenics to issue
        an
        unsecured Convertible Promissory Note for the principal sum of $750,000.
        The
        note will be for thirty-six months from the date of issuance, will accrue
        interest at the rate of 5% per year and will be payable in full at the end
        of
        the term.
  A
        copy of the Amending and Restating Agreement with
        Energenics is attached as an exhibit herein.
 
 Due
        to
        conditions in the global credit markets, Energenics has funded only a portion
        of
        the transaction. The Company received $1,250,000 in two deposits on November
        14,
        2007 and December 21, 2007 to be applied toward the equity portion of the
        transaction and $700,000 in two deposits on July 12, 2008 and August 11,
        2008 to
        be applied toward the Promissory Note. Upon receipt of the final $50,000
        portion
        of the Promissory Note and the payment of the required Irish stamp tax
        associated with the transfer of the O2Diesel Asia shares, the transaction
        will
        close. The Company anticipates this closing to take place during the third
        quarter of 2008.
  **KL
      Process Transaction**




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




As
      part
      of the KL Agreement, the Company agreed to issue 1,000,000 shares of the
      Company’s common stock to KL as consideration for the license as well as certain
      royalty and design services fees.  The stock is to be issued upon
      commencement of the first project under the KL Agreement or 18 months after
      the
      effective date of the KL Agreement, whichever is earlier. The common stock
      will
      be issued to the accredited investor in a transaction that will be exempt from
      registration pursuant to Section 4(2) of the Securities Act and/or
      Regulation D promulgated under the Securities Act.





**YellTec
      Transaction**




On
      April 6, 2008, the Company entered into a Letter of Intent (the “LOI”) to
      acquire all the outstanding shares of YellTec GmbH (“YellTec”), a German company
      which specializes in biofuels distribution.  YellTec is focused on small to
      medium size truck fleets and operates an exclusively German based network of
      its
      own strategically located fueling points.




The
      Company was to acquire all the outstanding shares of YellTec for €3 million or
      $4.7 million at current exchange rates subject to a purchase price adjustment
      as
      described in the LOI and was to issue 5.3 million shares of the Company’s
      stock.  The Company was working with an international investment banking
      firm to identify potential investors for this transaction.




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





The
      parties have agreed to terminate the LOI and not to pursue the acquisition
      in
      light of changed conditions in the market for vegetable oil products. On July
      24, 2008, the Company informed YellTec of its intention to terminate the LOI
      and
      any further efforts related to the transaction.


F-20





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**5.
      Government Appropriations**




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





In
      2002,
      the Company received an appropriation of $1,107,734 from the U.S. Department
      of
      Energy (“DOE”) to test the Company's fuel additive as well as its blended fuel,
      O2DieselTM. The appropriation was increased to $2,039,651 as of
      September 15, 2004. This appropriation is managed for the DOE by the
      National Renewable Energy Laboratory (“NREL”) under a contract which, as
      amended, continued until June 30, 2007. As of June 30, 2008, NREL had not
      yet closed this contract. 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, 2008 and December
      31, 2007, the Company had incurred the full cumulative costs of $2,039,651
      towards completion of the contract resulting in no balance of costs left to
      spend in order to complete the contract. From the inception of the contract
      in
      December 2002 through June 30, 2008 and December 31, 2007, the Company
      billed NREL $1,631,720 of which $16,317 is included in other receivables as
      of
      June 30, 2008 and December 31, 2007.





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





In
      2003,
      the Company received an appropriation of $1,123,834 to test the Company's fuel
      additive under the California Air Resources Board (CARB) Diesel Emissions
      Control Strategy (DECS) verification rules. The Company is eligible to
      receive reimbursements of 80% of costs incurred under a contract up to the
      appropriation amount. This appropriation is managed for the DOE by NREL, the
      National Renewable Energy Laboratory. As of June 30, 2008 and December 31,
      2007,
      the Company had incurred cumulative costs of $1,057,288 and $986,222,
      respectively, towards completion of the contract, leaving a balance of $66,546
      and $137,612, respectively, in costs to complete the contract. From the
      inception of the contract through June 30, 2008 and December 31, 2007, the
      Company billed NREL $845,830 and $786,847, respectively, of which $25,945 and
      $57,690 is included in other receivables as of June 30, 2008 and December 31,
      2007, respectively.





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





During
      2004 and 2005, the Company received $1,000,000 in available appropriations
      for
      the purpose of continued testing and verification of our fuel additive. The
      Company has submitted its proposal for several possible test projects and
      expects to enter into a contract, eligible for approximately 80% reimbursement,
      in the third quarter of 2008.





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




F-21


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**5.
      Government Appropriations (continued)**





**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 DoD. Under this contract, the Company's O2Diesel TM 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
      O2Diesel TM as a
      viable alternative fuel for use by the Air Force. Work on this contract
      commenced on November 1, 2004 and continued through November 30, 2006.
      Notwithstanding that the agreement for this contract was signed in January
      2005,
      the Company was asked to begin work in 2004 and, by a letter from 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 DoD 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. As of December 31, 2006, costs totaling $1,011,215 had been
      incurred and billed, leaving a remaining contract balance of $1,349. As of
      December 31, 2007, this contract was formally closed.





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





The
      Company received an appropriation during 2005 of approximately $910,000 from
      the
      DoD. Concurrent Technologies Corporation (CTC) manages this appropriation on
      behalf of the DoD. This contract contains a payment schedule based on meeting
      performance milestones. Four milestones were achieved during 2006 which resulted
      in issuing $530,000 of invoices during 2006. The primary objective of this
      contract is to create potential fuels using the Company additive that contains
      no more than 80% petroleum. If this project is successful, an application will
      be made to DOE for "alternative fuel" status, creating an incentive for federal
      customers to use the fuel. Part of this research entails conducting
      demonstrations in various climates at three Air Force bases, including Nellis
      Air Force Base (expanded fleet) in Nevada and Minot Air Force Base in North
      Dakota. As of June 30, 2008 and December 31, 2007, $910,000 and $860,576 in
      expenses had been incurred, leaving an available contract balance of $0 and
      $49,424, respectively. In addition to the $910,000 and $715,000 in expenses
      that
      had been invoiced as of June 30, 2008 and December 31, 2007, based on achieving
      all the contract milestones through those dates, the Company has recorded
      Unbilled Appropriations of $0 and $145,576 at June 30, 2008 and
      December 31, 2007, respectively, in the consolidated balance
      sheets.




**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 O2Diesel TM .
      The
      Company entered into a contract for $575,000 in 2007. As of June 30, 2008,
      lab
      testing of a new fuel combining O2Diesel TM ,
      biodiesel, and diesel had been conducted and field-testing was completed at
      Nellis Air Force Base in Las Vegas, Nevada and was started at Barksdale Air
      Force Base in Shreveport, Louisiana.




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




In
      2006,
      the Company received an appropriation of approximately $1,000,000 for continued
      testing and verification of O2Diesel. Of this amount, $688,710 was added during
      the third quarter of 2007 to the contract described in DoD (4), for a total
      contract amount of $1,263,710 at December 31, 2007. This contract was further
      amended during the second quarter of 2008 to delete several tasks and replace
      them which caused a net reduction of $67,224 from the total amount, resulting
      in
      a revised total contract amount of $1,196,486 at June 30, 2008. These funds
      will
      be used by CTC to conduct lab testing on behalf of this project. The contract
      with CTC contains a payment schedule based on meeting performance milestones.
      Ten and six milestones were achieved which resulted in the issuance of invoices
      totaling $889,087 and $620,536 as of June 30, 2008 and December 31, 2007,
      respectively. Aggregate costs of $299,146 and $144,556 were incurred under
      this
      contract resulting in the balance of $589,941 and $475,980 being recorded in
      deferred grants in the consolidated balance sheets at June 30, 2008 and
      December 31, 2007, respectively.




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




In
      2007,
      the Company received an appropriation of approximately $1,600,000 for continued
      testing and verification of O2Diesel TM .
      The
      Company has submitted its proposal for several possible test projects and
      expects to enter into a contract for approximately $1,188,000 in the third
      quarter of 2008.




F-22


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**6.
      Other Receivables**




Significant
      components of the Company’s Other Receivables at June 30, 2008 and
      December 31, 2007 are as follows:





June 30,
            
            December 31,2008
            
            2007NREL
                contract (DOE)
            
            $
            42,263
            
            $
            74,007CTC
                contract (DoD)
            
            
            60,066
            
            
            -Receivables
                related to product demonstrations (Spain)
            
            
            44,561
            
            
            45,407VAT
                receivables (Spain)
            
            
            64,890
            
            
            57,594Other
            
            
            36,186
            
            
            15,611$
            247,966
            
            $
            192,619





**7.
      Accrued Expenses**




Significant
      components of the Company’s Accrued Expenses at June 30, 2008 and
      December 31, 2007 are as follows:





June 30,
            
            December 31,2008
            
            2007Legal
                and professional fees
            
            $
            105,196
            
            $
            234,721Payroll-related
                liabilities
            
            
            99,555
            
            
            30,304Severance
                payments
            
            
            55,252
            
            
            190,508Other
            
            
            60,452
            
            
            112,909$
            320,455
            
            $
            568,442





**8.
      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, 2008 and December 31, 2007
      are as follows:




June 30,
              2008
            
            December 31,
              2007Net operating
                loss carryforwards
            
            $
            13,070,913
            
            $
            11,831,969Deferred
                revenue
            
            
            (24,265
            )
            
            453,020Accrued
                expenses
            
            
            194,648
            
            
            255,818Total
                deferred tax assets
            
            
            13,241,296
            
            
            12,540,807Valuation
                allowance
            
            
            (13,241,296
            )
            
            (12,540,807
            )Net
                deferred tax assets
            
            $
            -
            
            $
            -




Management
      has determined that a valuation allowance equal to 100% of the existing deferred
      tax asset is appropriate given the uncertainty regarding the ultimate
      realization of these assets. At June 30, 2008, the Company had Federal and
      state
      net operating loss carryforwards of approximately $29.9 million for income
      tax purposes. If not used, these carryforwards begin to expire in 2021. 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 a
      result, certain amounts of the net operating loss carryforwards may expire
      without being utilized. As of June 30, 2008, the Company had an Irish net
      operating loss carryforward of approximately $837,000 which can be carried
      forward indefinitely, a cumulative Spanish loss of approximately
      $2.5 million and a Brazilian net operating loss of approximately
      $1.9 million that may be carried forward indefinitely, but which is subject
      to annual usage limitations.




F-23


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**8.
      Income Taxes (continued)**




In
      July 2006, the FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* - *an
      interpretation of FASB Statement No. 109* ”
(“FIN
      48”). FIN 48 clarifies the accounting and disclosure for uncertainty in tax
      positions, as defined and prescribes the measurement process and a minimum
      recognition threshold, for a tax position taken or expected to be taken in
      a tax
      return, that is required to be met before being recognized in the financial
      statements. Under FIN 48, the Company must recognize the tax benefit from an
      uncertain tax position only if it is more likely than not that the tax position
      will be sustained on examination by the taxing authorities, based on the
      technical merits of the position. The tax benefits recognized in the financial
      statements from such a position are measured based on the largest benefit that
      has a greater than 50% likelihood of being realized upon ultimate
      resolution.




The
      Company is subject to the provisions of FIN 48 as of January 1, 2007, and
      has analyzed filing positions in all of the U.S. federal and state jurisdictions
      where it is required to file income tax returns, its federal and state tax
      returns in Ireland, Spain and Brazil and all open tax years in these
      jurisdictions. The Company has identified its U.S. federal tax return and its
      state tax returns in Delaware and California as “major” tax jurisdictions as
      defined. Based on the Company’s evaluation, we have concluded that there are no
      significant uncertain tax positions requiring recognition in our financial
      statements. Our evaluation was performed for the tax years which remain subject
      to examination by the major U.S. tax jurisdictions (tax years ended
      December 31, 2004 to December 31, 2007) and for the tax years which
      remain open for examination in Ireland (December 31, 2007), Spain
      (December 31, 2007) and Brazil (December 31, 2007). Based on this
      evaluation, no reserves for uncertain income tax positions have been recorded
      pursuant to FIN 48 during the period ended June 30, 2008 and the Company does
      not anticipate that it is reasonably possible that any material increase or
      decrease in its unrecognized tax benefits will occur within twelve months.
      In
      addition, the Company did not record a cumulative effect adjustment related
      to
      the adoption of FIN 48.




Upon
      adoption on January 1, 2007 and as of June 30, 2008, the Company had no
      unrecognized tax benefits or accruals for the potential payment of interest
      and
      penalties. The Company’s policy for recording interest and penalties associated
      with tax audits is to record such items as a component of income or loss before
      provision (benefit) for income taxes. Penalties are recorded in other expenses,
      and interest paid or received is recorded in interest expense or interest
      income, related to the settlement of tax audits for certain prior periods.
      Since
      the adoption of FIN 48, no interest or penalties have been recorded relating
      to
      the settlement of tax audits.




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




**9.
      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.


F-24


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




**Common
      Stock and Warrant Activity**




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 additional paid-in capital.




Subsequent
      to its first private placement in 2003, the Company undertook to raise an
      additional $3.5 million through a follow-on private placement of our common
      stock (the “Follow-On Private Placement”). In the Follow-On Private Placement,
      we raised $1,535,570, before expenses, and issued 1,025,784 shares of our common
      stock at a price of $1.50 per share. The Follow-On Private Placement was closed
      on March 31, 2004. There was no underwriter involved in the Follow-On
      Private Placement. Sales of common stock under the Follow-On Private Placement
      that were completed in non-U.S. transactions were exempt from registration
      pursuant to Regulation S promulgated under the Securities Act. The sales of
      common stock under the Follow-On Private Placement to accredited U.S. investors
      were exempt pursuant to Regulation D promulgated under the Securities
      Act.




On
      July 17, 2007, the Company repurchased 100,000 shares of its common stock
      for treasury for an aggregate purchase price of $40,100. The purchase price
      was
      $0.401 per share, which was the daily volume weighted average for the five
      trading days prior to the day the Company’s board of directors approved the
      repurchase.  In December 2007, management decided to retire these
      shares.




**$10.0
      Million Private Placement**




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




Concurrent
      with entering into the Purchase Agreement, the Company entered into a
      registration rights agreement with Fusion Capital (the “Registration Rights
      Agreement”). Under the Registration Rights Agreement, the Company filed a
      registration statement with the SEC covering the shares that have been issued
      or
      may be issued to Fusion Capital under the Purchase Agreement. Subject to earlier
      termination at the Company’s discretion, Fusion Capital’s purchases commenced
      after June 8, 2007 when the SEC declared effective the registration
      statement related to the transaction. Generally, the Company has the right
      but not the obligation from time to time to sell an aggregate of up to 12
      million shares of the Company’s common stock to Fusion Capital in amounts
      between $100,000 and $1 million depending on certain conditions. The Company
      has
      the right to control the timing and amount of any sales of the Company’s shares
      to Fusion Capital. The purchase price of the shares will be determined based
      upon the market price of the shares of common stock without any fixed discount.
      Fusion Capital shall not have the right or the obligation to purchase any shares
      of the Company’s common stock on any business day that the price of the
      Company’s common stock is below either $0.50 or $0.60, depending on the
      transaction size of the purchase. The agreement may be terminated by the Company
      at any time at its discretion without any cost to the Company.




During
      the three and six months ended June 30, 2008, the Company did not execute any
      transactions under this agreement.  During the three months ended June 30,
      2007, the only period during which transactions have occurred since the
      effective date of this agreement, the Company executed five separate
      transactions, selling a total of 970,994 shares of common stock at an average
      price of $0.515 per share for total proceeds of $500,000.




**$2.52
      Million Private Placement**




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


F-25


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




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




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




**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
      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.




F-26


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




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.




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 accreted
      the value of the beneficial conversion feature through equity and recorded
      a
      deemed dividend to preferred stockholders. These dividends amounted to $0 for
      the three and six months ended June 30, 2008 and 2007 and $6,200,005 for the
      period from October 14, 2000 (inception) through June 30, 2008,
      respectively, and are included in the consolidated statements of operations.
      In
      April 2006, the holders of both the Series A and Series B
      Convertible Preferred Stock exercised all of their conversion rights and
      converted 1,550,000 shares of Convertible Preferred Stock into 15,500,000 shares
      of common stock.




**Warrants**




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




On
      February 3, 2006, the Company offered existing warrant holders from the
      $2.0 million 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 and
      June 12, 2006, several other existing warrant holders elected to exercise
      their warrants at the contract price identified in their warrant documentation.
      Proceeds for these exercises were $865,452 (after expenses) for the purchase
      of
      1,287,857 shares of common stock.




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


F-27


**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**


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




**Options**




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




The
      following table shows the outstanding options granted under the Incentive
      Plan.




**Weighted Ave****Weighted Ave**
            
            **Remaining****Shares**
            
            **Exercise Price**
            
            **Contractual Term**Outstanding
                at January 1, 2004
            
            
            500,000
            
            $
            1.50
            
            
            -Granted
                in 2005
            
            
            5,450,000
            
            $
            1.50
            
            
            7.3Exercised
                in 2005
            
            
            -Forfeited
                or Expired
            
            
            -Outstanding
                at December 31, 2005
            
            
            5,950,000
            
            $
            1.50
            
            
            7.3Granted
                During the Year Ended December 31, 2006
            
            
            1,350,000
            
            $
            1.28
            
            
            8.0200,000
            
            $
            1.50
            
            
            8.0100,000
            
            $
            0.71
            
            
            8.4Exercised
                During the Year Ended December 31, 2006
            
            
            -Forfeited
                or Expired
            
            
            (100,000
            )
            $
            1.28Outstanding
                at December 31, 2006
            
            
            7,500,000
            
            $
            1.43
            
            
            7.2Granted
                During the Year Ended December 31, 2007
            
            
            250,000
            
            $
            1.50
            
            
            9.5Exercised
                During the Year Ended December 31, 2007
            
            
            -Forfeited
                or Expired
            
            
            (1,575,000
            )
            $
            1.48Outstanding
                at December 31, 2007
            
            
            6,175,000
            
            $
            1.45
            
            
            7.4Granted
                During the Six Months Ended June 30, 2008
            
            
            -Exercised
                During the Six Months Ended June 30, 2008
            
            
            -Forfeited
                or Expired
            
            
            (200,000
            )
            $
            1.28Outstanding
                at June 30, 2008
            
            
            5,975,000
            
            $
            1.45
            
            
            7.4Exercisable
                at June 30, 2008
            
            
            5,772,875
            
            $
            1.46
            
            
            7.4




**Restricted
      Stock Awards**




On
      November 4, 2004, the Company entered into an investor relations consulting
      agreement for a term of four years. In exchange for services, the Company
      awarded the consultant 50,000 shares of restricted stock as settlement of this
      agreement, effective November 9, 2007 and recognized $23,500 of consulting
      expense in 2007.




On
      September 20, 2005, the Company entered into an investor relations
      consulting agreement for a term of one year which the parties subsequently
      agreed to renew on an annual basis. In exchange for services, the Company paid
      the consultant $7,250 per month. In addition, the Company awarded the consultant
      100,000 shares of restricted stock. As of June 30, 2008, the restrictions on
      all
      100,000 shares issued under this contract had lapsed and such shares were earned
      and able to be sold.  On March 31, 2008, the Company awarded 120,000
      shares of restricted stock as final payment for services rendered and terminated
      this agreement. The $36,238 of expense related to this award was offset entirely
      by the settlement of amounts previously accrued for such services.  For the
      three and six months ended June 30, 2008 and 2007 and for the period
      October 14, 2000 (inception) through June 30, 2008, the Company recognized
      $0, $0, $0, $0 and $81,500, respectively, of net expense in connection with
      these stock awards.


F-28






**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




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




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




On
      May 14, 2007, the Company entered into an investor relations consulting
      agreement for a term of two months. In exchange for services, the Company paid
      the consultant a fee of $10,000. In addition, the Company awarded the consultant
      50,000 shares of restricted stock. In connection with the stock award, the
      Company recognized $0, $0, $27,000, $27,000 and $27,000 of consulting expense
      for the three and six months ended June 30, 2008 and 2007 and for the period
      October 14, 2000, (inception) through June 30, 2008,
      respectively.




On
      May 16, 2007, the Company entered into a second investor relations
      consulting agreement for a term of six months. In exchange for services, the
      Company awarded the consultant 440,000 shares of restricted stock. In connection
      with the stock award, the Company recognized $0, $0, $0, $213,000 and $213,000
      of consulting expense for the three and six months ended June 30, 2008 and
      2007
      and for the period October 14, 2000, (inception) through June 30, 2008,
      respectively. Pursuant to the terms of the consulting agreement, 220,000 shares,
      120,000 shares and 100,000 shares of the restricted stock were earned by the
      consultant on May 16, 2007, July 16, 2007 and September 17, 2007,
      respectively. As of June 30, 2008, the restrictions on the 440,000 shares issued
      under this contract have lapsed and such shares were earned.


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





In
      the
      three months ended June 30, 2008, the Company issued 1,071,500 shares of
      restricted stock to two vendors in lieu of cash payments for investor relations
      services. The result of these settlements was to reduce accounts payable by
      $90,000 and to increase professional fees by $130,000.




The
      following schedule presents shares of common stock issued and outstanding and
      reserved for future issuance as of June 30, 2008:




Common
                Shares Outstanding
            
            
            
            
            
            88,051,752Reserved
                For Future IssuanceOptions
                granted to officers, directors, employees and consultants
            
            
            5,975,000Unearned
                restricted stock award to former officer
            
            
            166,666Unearned
                common stock issued for commitment shares
            
            
            271,756Warrants
            
            
            12,683,997
            
            
            19,097,419Total
                shares issued and outstanding and reserved for future issuance at
                June 30,
                2008.
            
            
            
            
            
            107,149,171




F-29




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**Notes
      to Consolidated Financial Statements (Continued)**


**(Unaudited)**




**10. Related
      Party Transactions**




A
      company
      controlled by a former Chairman of the Board provided office space, accounting
      and other services to the Company at a cost of approximately $2,500 per month,
      through June 2007, to the Company’s Irish subsidiary. For the three and six
      months ended June 30, 2008 and 2007 and for the period October 14, 2000,
      (inception) through June 30, 2008, the Company paid $0, $0, $8,361, $24,871
      (of
      which approximately $13,800 related to the first six months of 2007), and
      $207,595, respectively, to the company controlled by the former Chairman. At
      June 30, 2008, there was no amount accrued as a payable to this related
      party.




Included
      in Other receivables at June 30, 2008 and December 31, 2007 is $24,729 and
      $15,611, respectively, which primarily represents travel advances made to
      employees. Included in Accounts payable at June 30, 2008 and December 31,
      2007 is $263,646 and $150,486, respectively, which primarily represents
      directors’ fees and travel expenses reimbursable to employees.




The
      Company has entered into two separate consulting contracts with two shareholders
      of its Brazilian subsidiary for the purpose of providing office rent and
      administrative services and in lieu of employment contracts with these two
      individuals. These two contracts provide support significant to the operation
      of
      the Brazilian subsidiary. The company incurred expenses of $42,578, $83,645,
      $34,342, $70,676 and $704,598 for the three and six months ended June 30, 2008
      and 2007 and for the period October 14, 2000 (inception) through June 30,
      2008, respectively.




**11.
      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, 2008, future minimum
      lease
      payments under non-cancelable operating leases were as follows:




Operating
      Leases




2008
            
            $
            62,9192009
            
            
            15,400Total
            
            $
            78,319




Rent
      expense under the leases with unrelated parties was $46,874 and $86,070 the
      three and six months ended June 30, 2007 and $44,240, $93,340, and $607,472
      for
      the three and six months ended June 30, 2008 and for the period October 14,
      2000 (inception) through June 30, 2008, respectively.




**12.
      Subsequent Events**




**YellTec
      Transaction**




On
      April 6, 2008, as previously disclosed, the Company entered into an LOI to
      acquire all the outstanding shares of YellTec, a German company which
      specializes in biofuels distribution. The
      parties have agreed to terminate the LOI and not to pursue the acquisition
      in
      light of changed conditions in the market for vegetable oil products. On July
      24, 2008, the Company informed YellTec of its intention to terminate the LOI
      and
      any further efforts related to the transaction.


F-30




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**





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




**OVERVIEW**




**Business
      Plan**




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, 2008.




O2Diesel’s
      predecessor, Dynamic Ventures, Inc., was incorporated in the State of
      Washington on April 24, 2000. Dynamic Ventures, Inc. changed its name
      to O2Diesel 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.




From
      July 2003 through July 2008, the Company has raised approximately $38
      million for its operations.




**Transactions
      During the Second Quarter of 2008**




**ProEco
      Transaction**




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




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




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




1




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**




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




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




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




Under
      the
      terms of the letter of intent for the share exchange agreement, the Company
      agreed to enter into a secured loan agreement with ProEco for the purposes
      of
      financing the purchase options for the land to be used for the ethanol plant
      and
      certain engineering and permitting work required for the closing of the ProEco
      share exchange.  The annual interest rate on the loan is 7% and the
      maturity date of the loan was December 15, 2007.




Current
      trends in the ethanol industry have seen increases in the price of corn and
      other feedstocks as well as a decline in the average selling price of
      ethanol.  For a number of new plant construction projects, the lack of EPC
      contractor availability has resulted in increased costs and delays in completion
      dates.  On January 8, 2008, the Company announced that due to
      unfavorable market conditions for raising capital for ethanol plants, the
      Company and ProEco had entered into an agreement to extend the Share Exchange
      Agreement and the maturity date of the loan from the Company to ProEco until
      January 31, 2008.  These agreements were subsequently extended again
      until February 29, 2008.  On March 19, 2008, the Company and
      ProEco entered into a letter agreement terminating the Share Exchange Agreement
      and extending the maturity date of the loan from February 29, 2008 until
      November 30, 2008.  The Company and ProEco have agreed to continue to
      develop the Ethanol Plant when conditions in the capital markets improve. 
Management has evaluated this project based on its assessment of the challenges
      to financing projects of this nature, posed by the present debt and equity
      markets, as well as the limited likelihood that a buyer will be identified
      for
      this project in the near future.  Accordingly the Company believes that it
      is prudent not to assign a value to this asset.  As such, an impairment
      charge of $1,288,614 was warranted and this adjustment was recorded in
      December 2007.





During
      the period ended June 30, 2008, the Company devoted no significant activity
      to the ProEco transaction. ProEco has retained the documentation developed
      to
      implement the proposed project and has secured its option rights to the land
      at
      the site until October 15, 2008 through an agreement with the Belle Fourche
      Development Corporation in South Dakota. Both the Company and ProEco continue
      to
      monitor market conditions for the development and financing of ethanol plants
      but had not committed to moving forward on the project as of June 30, 2008.
      The
      Company has agreed with ProEco to release the land option in the event an
      alternative project for the property becomes available.




The
      following table summarizes the significant assets and liabilities of ProEco
      as
      of June 30, 2008 and December 31, 2007:




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




ProEco
      expenses, including the $1,288,614 impairment charge and after elimination
      of
      intercompany transactions, of $2,258, $17,258 and $1,706,545 for the three
      and
      six months ended June 30, 2008 and the period October 14, 2000
      (inception) through June 30, 2008, respectively, are also reflected in the
      Company’s Consolidated Statements of Operations.




**Energenics
      Transactions**




On
      October 17, 2007, the Company announced that it had entered into a private
      financing agreement and a joint venture transaction with Energenics Holdings
      Pte
      Ltd (“Energenics”) funding and commercial support for the development of the
      Asian market. At that time, the parties entered into a Common Stock and Warrant
      Purchase Agreement (the “ *Purchase*  *Agreement* ”)
      pursuant to which Energenics agreed to purchase 2,551,020 shares of the
      Company’s common stock in a private placement, for total proceeds of
      approximately $1.25 million. As part of the transaction, the Company agreed
      to
      issue a warrant to purchase 1,275,510 shares of common stock at an exercise
      price of $0.50 per share, which warrant would be issued upon the closing of
      the
      transactions contemplated by the Purchase Agreement and would become exercisable
      from the date that is six months following the date of issuance until October
      17, 2012 (“ *Investment
      Warrant* ”).





The
      parties also entered into a Shareholders Agreement, in which Energenics and
      the
      Company would jointly develop the market for O2DieselTM in Asia through O2Diesel
      Asia Limited (“O2Diesel Asia”). Energenics agreed to pay the Company $750,000
      for a fifty percent (50%) equity interest in O2Diesel Asia. The balance of
      the
      interest in O2Diesel Asia was to be held by O2Diesel Europe Limited,
      a wholly-owned subsidiary of the Company. Pursuant to the Supply and
      Distribution Agreement, dated September 15, 2006 (“*Supply Agreement*”),
      O2Diesel has supplied its additive to Energenics for the manufacture and
      distribution of O2DieselTM in the Asian Pacific and South
      Asia.




2




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**





The
      parties also entered into a License agreement(“ *O2Diesel
      Asia License Agreement* ”),
      whereby O2Diesel Europe Limited (formerly AAE Technologies International Plc)
      (“ *O2Diesel
      Europe* ”)
      would
      license to O2Diesel Asia certain patents and know-how that are required to
      make
      and sell O2DieselTM in the Territory in exchange for certain payments pursuant to
      the Shareholders Agreement. In addition, the Company was to enter into a similar
      License agreement (the “ *License Agreement* ”
and
      together with the O2Diesel Asia License Agreement, the “ *Licenses* ”),
      with
      O2Diesel Asia, pursuant to which the Company would pay to O2Diesel Asia a
      royalty based on sales of the Company’s product in the Territory.





As
      part
      of the transaction, upon the purchase of a certain quantity of O2D05 or the
      equivalent, the Company would also issue a warrant to purchase 1,500,000 shares
      of common stock at an exercise price of $0.50 per share, which warrant would
      be
      exercisable during the period from the date of issuance until October 17,
      2012 (“ *JV
      Warrant”* ).





Also,
      as
      part of the transaction, upon the achievement by Energenics of certain levels
      of
      additional purchases of O2D05 or the equivalent, the Company was to issue
      additional warrants to purchase up to an aggregate of 6,500,000 shares of common
      stock at a price per share equal to the lesser of $0.50 or 106% of the closing
      price per share (rounded to the nearest cent) of the Company’s common stock on
      the American Stock Exchange on the date such warrants are earned (“ *Market Development Warrants* )
      ,” The
      Market Development Warrants were to be exercisable from the date of issuance
      to
      October 17, 2012.





On
      December 10, 2007, the Company and Energenics entered into an amendment (the
      “ *Amendment* ”)
      to the
      Common Stock and Warrant Purchase Agreement, dated October 17, 2007. Pursuant
      to
      the Amendment, the Company agreed to increase the number of shares of common
      stock by 782,313 shares to 3,333,333 shares, which reduced the per share price
      from $0.49 to $0.375. The per share price of $0.375 represented 121% of the
      current market price on the American Stock Exchange the day prior to the signing
      of the Amendment. In addition, the Company agreed to issue an additional 391,157
      shares exercisable pursuant to the warrant associated with the Investment
      Warrant. In addition, the Company was to issue additional warrants (the
“ *Additional
      Warrants* ,”
and
      collectively, with the Investment Warrant, the Market Development Warrants
      and
      the JV Warrant, (the “ *Warrants* ”)
      to
      purchase shares of common stock, upon the purchase of certain quantities of
      O2D05 or the equivalent. Pursuant to the Amendment, the exercise price per
      share
      for the shares associated with these Additional Warrants was also reduced to
      $0.375.




All
      other
      terms and conditions of the transaction remain as provided in the Purchase
      Agreement.





The
      common stock and the Warrants were to be issued to the accredited investor
      in a
      transaction that would be exempt from registration pursuant to Section 4(2)
      of
      the Securities Act of 1933, as amended (the “Securities Act”), and/or Regulation
      D promulgated under the Securities Act.





On
        June
        17, 2008, the Company entered into an Amending and Restating Agreement with
        Energenics to reflect the renegotiated terms of previously announced agreements
        to provide $2,000,000 of funding and commercial support to develop the Asian
        market for O2DieselTM, the Company’s ethanol diesel fuel blend.
 
 According
        to the terms of the Amending and Restating Agreement, the original Common
        Stock
        and Warrant Purchase Agreement dated October 17, 2007 and the subsequent
        Amendment are to be terminated and the previously issued shares of O2Diesel
        Corporation common stock are to be retired by the Company when the transaction
        closes. The original Shareholder’s Agreement between Energenics and the Company
        will be amended to reflect that Energenics agreed to pay the Company $1,250,000
        for an eighty percent (80%) equity interest in O2Diesel Asia. The balance
        of the
        interest in O2Diesel Asia is to be held by O2Diesel Europe Limited, a
        wholly-owned subsidiary of the Company. The existing Warrants (as amended),
        Licenses and Supply Agreement will remain unchanged.
 
 Under
        the
        terms of the Amending and Restating Agreement, the original shares of the
        Company’s common stock issued to Energenics (in escrow) are to be retired and
        $1,250,000 is to be paid for the 80% equity interest in O2Diesel Asia. In
        addition, the Company will enter into an agreement with Energenics to issue
        an
        unsecured Convertible Promissory Note for the principal sum of $750,000.
        The
        note will be for thirty-six months from the date of issuance, will accrue
        interest at the rate of 5% per year and will be payable in full at the end
        of
        the term.
 
 Due
        to
        conditions in the global credit markets, Energenics has funded only a portion
        of
        the transaction. The Company received $1,250,000 in two deposits on November
        14,
        2007 and December 21, 2007 to be applied toward the equity portion of the
        transaction and $700,000 in two deposits on July 10, 2007 and August 11,
        2008 to
        be applied toward the Promissory Note. Upon receipt of the final $50,000
        portion
        of the Promissory Note and the payment of the required Irish stamp tax
        associated with the transfer of the O2Diesel Asia shares, the transaction
        will
        close. The Company anticipates this closing to take place during the third
        quarter of 2008.





**KL
      Process Transaction**




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





3




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**




As
      part
      of the KL Agreement, the Company agreed to issue 1,000,000 shares of the
      Company’s common stock to KL as consideration for the license as well as certain
      royalty and design services fees.  The stock is to be issued upon
      commencement of the first project under the Agreement or 18 months after the
      effective date of the Agreement, whichever is earlier. The common stock will
      be
      issued to the accredited investor in a transaction that will be exempt from
      registration pursuant to Section 4(2) of the Securities Act and/or
      Regulation D promulgated under the Securities Act.




**YellTec
      Transaction**




On
      April 6, 2008, the Company entered into a Letter of Intent (the “LOI”) to
      acquire all the outstanding shares of YellTec GmbH (“YellTec”), a German company
      which specializes in biofuels distribution.  YellTec is focused on small to
      medium size truck fleets and operates an exclusively German based network of
      its
      own strategically located fueling points.




The
      Company was to acquire all the outstanding shares of YellTec for €3 million or
      $4.7 million at current exchange rates subject to a purchase price adjustment
      as
      described in the LOI and was to issue 5.3 million shares of the Company’s
      stock.  The Company was working with an international investment banking
      firm to identify potential investors for this transaction.




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





The
      parties have agreed to terminate the LOI and not to pursue the acquisition
      in
      light of changed conditions in the market for vegetable oil products. On July
      24, 2008, the Company informed YellTec of its intention to terminate the LOI
      and
      any further efforts related to the transaction.




**Delisting
      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 Company has received
      approvals to list 75,244,983 more shares of our common stock so that the
      total number of shares approved for listing is 121,763,881. Our shares began
      to
      trade on the Exchange on July 1, 2004.




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




On
      July 27, 2007, the Company filed a plan with the Exchange describing the
      steps it planned to take to return to full compliance.  On
      September 13, 2007, the Company received a written notice from the AMEX
      indicating that AMEX had reviewed and accepted the Company’s plan to regain
      listing qualifications compliance.  With the acceptance of the plan, the
      Company would be able to continue its listing during the plan period pursuant
      to
      an extension granted until December 29, 2008.  The AMEX notice also
      advised the Company that, in addition to the previously disclosed deficiency
      with respect to Section 1003(a)(iii) of the AMEX Company Guide, it had
      triggered an additional deficiency with respect to Section 1003(a)(ii).





Under
      the
      terms of the notice from AMEX, the Company was to continue to provide AMEX
      staff
      with updates regarding initiatives set forth in its plan of compliance.  If
      the Company was not in compliance on December 29, 2008, or the Company did
      not make progress consistent with the plan during the interim period, the AMEX
      would likely initiate procedures to de-list the Company’s common stock. On
      February 7, 2008, the Company received notice from the staff of the AMEX
      that due to the deferral of the ProEco project, as described above, the Company
      was no longer demonstrating progress consistent with the plan and had determined
      to proceed with an application to the Securities and Exchange Commission to
      remove the common stock of the Company from listing and registration on AMEX.
      This action was taken because the Company is not in compliance with
      Section 1003(a)(ii) and (iii) of the AMEX Company Guide.





4





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**





On
      February 12, 2008, the Company appealed the delisting determination by
      requesting an oral hearing to present its plan, its progress in achieving the
      plan and maintaining its AMEX listing. On April 4, 2008, the Company
      received notice from AMEX that it was not in compliance with
      Sections 1003(a)(i) and (iv) of the AMEX Company Guide. 
Subsequent to an oral hearing on April 15, 2008, the Company received
      notice on April 21, 2008 from AMEX indicating its determination to prohibit
      the continued listing of the Company’s common stock on the Exchange and to
      initiate delisting proceedings.





On
      April 28, 2008 the Company announced that it began trading on the Pink
      Sheet Electronic Quotation Service under the trading symbol OTOD.PK. The
      Company’s shares then began to trade under the symbol OTOD.OB on or about May
      26, 2008.




**Operations**




During
      the second quarter of 2008, we continued our efforts to generate sales to our
      targeted fleet customers in North America, South America and India, as well
      as
      our efforts to develop targeted demonstrations in Europe.




*North
      America*




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




Ø
            Current
                and projected quantity of diesel fuel
                consumption;


Ø
            High
                population centers under strict air quality
                regulations;


Ø
            Municipal
                transit and school bus fleets with an emphasis on public policy and
                a
                positive environmental image;


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


Ø
            Off-road
                construction equipment;


Ø
            Diesel
                equipment used by port facilities and large-scale mining operations;
                and  Ø
            Military
                installations in non-combat
                vehicles.





In
      the
      U.S., O2Diesel’s second quarter sales and marketing efforts for fleet sales
      remained focused in the state of California and in the Midwest.  The
      Company maintained its commercial activities at the Port of Long Beach and
      pursued additional opportunities in this market segment at the ports of Oakland
      and Los Angeles. The Company continued its test demonstration at
      Nellis Air Force Base (Nevada) and completed a second demonstration at
      Minot Air Force Base (North Dakota) in which the Company’s technology was proven
      to be successful under extreme cold weather conditions.  During the second
      quarter of 2008, the Company implemented a third test demonstration for the
      Air
      Force at Barksdale Air Force Base (Louisiana) in which the Company’s technology
      is being tested under extreme humidity conditions.  Initial results from
      this demonstration have been consistent with the success we have had at Nellis
      and Minot. It is expected that this third test will be the final field
      demonstration required by the Air Force in order to implement a formal
      purchasing specification during the third quarter of 2008. As additional support
      for these projects, we are focused on conducting storage stability tests for
      our
      fuel as well as reviewing the training and procedures that will be required
      for
      a larger scale implementation of O2DieselTM and O28 on additional DoD
      installations.




We
      also
      maintained our CityHomeTM demonstration program as a means of documenting
      operating performance data.  CityHomeTM is a marketing and sales initiative
      directed at city 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 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.





5




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**




In
      the
      second quarter of 2008, we successfully completed our final CityHomeTM municipal
      bus fleet demonstration. We continued with several small school bus fleets
      in
      Chicago and South Dakota.  To date, we have used this initiative as a
      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 several CityHomeTM programs, the fleet demonstrations
      executed under this program have required significant financial support from
      the
      Company. As a result, we have limited new CityHomeTM programs to instances where
      we are assured of a level of sponsorship funding needed to cover all expenses
      of
      the demonstration. The Company’s future involvement with the CityHomeTM program
      has thus been reduced only to programs that can be considered cost
      neutral.




We
      continued our efforts to support and improve the logistics network required
      for
      the delivery of O2DieselTM to fleet and CityHomeTM customers during the second
      quarter. These efforts are focused on developing strategic relationships with
      ethanol producers and distributors in order to improve both quality consistency
      and price stability. During the second quarter, the Company started
      renegotiating its supply agreement with an ethanol industry group to supply
      limited amounts of ethanol at preferential pricing for our Midwestern
      customers.




During
      the latter half of 2007, the U.S. ethanol industry experienced several economic
      and logistical challenges to the general expansion of production capacity. 
The prices of various ethanol feedstocks, most notably corn, have increased
      while, at the same time, ethanol prices saw a general decline as new production
      capacity comes on line.  In addition, the demands on experienced EPC
      contractors increased, particularly with the need for qualified skilled labor
      to
      build new plants.  As a consequence, many new projects experienced
      increased construction costs and project delays at a time when the profitability
      of the industry was tested.  At the end of the year, market conditions for
      raising capital for ethanol plants had become so unfavorable that the Company
      announced its decision to delay the project with ProEco to develop an ethanol
      plant until conditions in the capital markets improve.




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, 2008, the
      Company continued its efforts to register O2DieselTM fuel with the EPA and
      submitted significant test data and documentation to support its position that
      O2DieselTM is “substantially similar” to diesel fuel and should qualify for EPA
      registration. The Company also continued its efforts to complete the protocols
      to allow O2DieselTM to be classified as a California Diesel Emissions Control
      Strategy (DECS) by the California Air Resources Board.




In
      addition, we continued to develop a revised ballot for incorporation of our
      fuel
      as an American Society for Testing and Materials (ASTM) specification. This
      revision is based on the results of the initial voting on the original ballot
      submitted in December 2006 as well as the subsequent ballot submitted in
      December 2007. The 2007 ballot showed a reduced number of negative votes
      which the task force has continued to respond to.  A member of the Company
      serves as the chairman of the subcommittee tasked with revising this ballot
      and
      the revision was re-submitted at the June 2008 ASTM international
      meeting.





While
      the
      ballot failed to pass at this meeting, the composition of negative votes has
      narrowed. The major topics preventing ASTM acceptance appear to now be centered
      on safety and engine warranty issues, both of which the Company feels have
      been
      substantially addressed through extensive testing and demonstration data and
      real world field usage of the fuel. The Company will continue to address these
      issues and anticipates making progress toward certification by the end of 2008.




Finally,
      during the second quarter we continued to develop contract proposals for
      submission to the Department of Energy and the Department of Defense to utilize
      the $2.6 million of available appropriations received in prior years. These
      appropriations were awarded for the purpose of continued testing and
      verification of O2DieselTM, including the requirements of both DECS and the U.S.
      military. The work undertaken for our regulatory approvals has taken more time
      than originally anticipated and, while we continue our efforts in these areas,
      it is not possible to predict when these final approvals will be
      obtained.





*South
      America*





In
      Brazil, the roll out of our product has been much slower than planned, despite
      the fact that we have succeeded in verifying our technology in several earlier
      demonstration fleets. The cost of ethanol in Brazil has shown seasonal market
      fluctuations, which has made it difficult to produce our blended fuel at a
      consistently cost competitive level. Also, obtaining government approvals and
      gaining market awareness has taken longer than we anticipated. In response
      to
      these issues, we have made a decision to follow a less aggressive marking
      strategy for Brazil and taken steps to reduce our overhead. We are targeting
      customers in this market on a very focused
      basis, supporting them with a small consulting staff that performs our marketing
      and technical functions. Our marketing plans have been scaled back until we
      have
      a solid base of customers. 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.




6


**O2Diesel
        Corporation**
 **(A
        Development Stage Company)**
 **June
        30, 2008**




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. O2Diesel currently cooperates on a
      non-exclusive basis with Brazil’s largest fuel distributor, BR, the distribution
      arm of the state-owned mineral oil company Petrobrás. 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.





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





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





While
      South America remains an important market, the timing of expanded commercial
      activity here continues to be slower than anticipated and the Company cannot
      predict when this will occur.





*Europe*





During
      the second quarter of 2008, the Company continued its efforts to define the
      EU
      regulatory requirements and to identify market opportunities for testing and
      potential commercialization.  Our efforts in this region focused on
      developing fuel blending capability, identifying flame arrestor and other
      hardware requirements for fleet fueling, working with local and EU regulators
      to
      clarify the application of existing regulations to ethanol-diesel as an
      alternative fuel, establishing procedures to be used to manage fleet conversions
      to our fuel and discussing test demonstration opportunities.  The Company
      continued its demonstration programs with municipal bus fleets in France
      (Veolia) and Spain (Tussam).  These demonstrations are funded by government
      grants and the Company.  Upon successful completion of these
      demonstrations, it is anticipated that the Company will have fulfilled the
      requirements to be able to market O2DieselTM in these countries on a commercial
      basis.  We have identified several additional fleet demonstration
      opportunities in Spain, Italy, the Netherlands and Belgium.  We expect
      these or other potential customers to develop into new demonstration programs
      in
      2008.





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





As
      mentioned earlier in this section, on July 24, 2008, the Company notified
      YellTec of its intent to terminate the LOI to acquire this German biofuels
      distribution company. However, the Company continues to believe that these
      types
      of transactions represent the appropriate strategy to achieve expanded
      participation in the broader biofuels industry as well as vertically integrating
      and controlling the cost of the ethanol fuel component for O2DieselTM.





*Asia*





Our
      exclusive distributor in this region, Energenics, continued its efforts to
      expand its participation with its first large municipal bus fleet in Karnataka,
      India.  The pace of the conversion of the remainder of this fleet during
      the second quarter continued slower than expected, which reduced orders for
      our
      product significantly. Energenics has indicated that they experienced delays
      in
      renewing their annual licenses for the sale of O2DieselTM, but that these
      regulatory issues will be overcome in time to place new orders during the third
      quarter of 2008. Energenics has continued to target additional large bus fleets
      in the state of Maharashtra, India.




7





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**





*Technical
      and Logistical Issues*





Significant
      technical and logistical issues continued to challenge our ability to generate
      sales in the second quarter of 2008. While we have made substantial progress
      in
      addressing these challenges, 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 fuel,
      (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 and (4) obtaining
      regulatory approval and an industry accepted specification for our
“e-Diesel” (ethanol-diesel)
      fuel. O2Diesel has implemented several strategies to meet these challenges
      and
      has undertaken a variety of activities to overcome them and to position
      O2DieselTM as a premium clean-burning fuel.





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





*(2)* **Sourcing
      and installation of flame arrestors and other devices:** As
      part of the process by which O2Diesel TM was
      approved for sale in California, the California Air Resources Board (“CARB”)
      established several conditions that we must adhere to on an ongoing basis.
      An
      important condition is that all storage tanks in which O2Diesel is stored and
      all vehicles that use the fuel must be fitted with devices know as flame
      arrestors. These 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. In 2004 and 2005, this issue proved to be a serious obstacle and
      negatively impacted our ability to efficiently commercialize our technology
      in
      the U.S. Even though this technology had been used for many years, flame
      arrestors in the required sizes and designs were not yet available as an “off
      the shelf” item for use with our fuel at that time. In addition, the Company was
      required to conduct significant research and development efforts to identify
      (and in some cases design) flame arrestors, adaptors, primer pumps and other
      equipment for vehicles that use O2Diesel TM in
      different climates and driving conditions. Since that time, the flame arrestor
      challenge has largely been resolved for the vehicles within O2Diesel’s target
      markets. Our technical staff works closely with each customer with regard to
      purchasing and installing flame arrestors and other devices for customer
      vehicles and storage facilities. We will work with customers to source and
      install these devices either directly or in a supervisory role





*(3)* **Negotiating
      reliable, price-competitive supplies of fuel grade ethanol** :    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 O2Diesel TM be
      of a consistently high quality and that it meet certain other specifications.
      We
      continue to work closely with the industry to identify ethanol suppliers who
      meet our criteria. In 2008, we began renegotiating our contract with an ethanol
      industry group to provide a supply of limited amounts of ethanol at preferential
      pricing for our Midwestern customers. In addition, the Company announced its
      intention to purchase a controlling interest in ProEco, an engineering company
      that was intending to build a new ethanol manufacturing facility in South
      Dakota. While this project has been deferred due to conditions in the financing
      markets for such construction projects, it remains the Company’s intention to
      obtain ownership interest in ethanol producing facilities so that we can assure
      competitively priced, high quality ethanol for use in our commercialization
      efforts.





In
      order
      to ensure fuel quality, we have developed a quality control function that
      constantly tests the ethanol, the diesel blended with our additive and the
      final
      blended fuel used by our customers. We have established our own laboratory
      facility to support and enhance our quality control standards, as well as to
      carry out the tests that are necessary to prepare a fleet for conversion to
      use
      O2Diesel TM .
      Additionally, the Company has installed several testing devices in the field
      so
      that samples can be evaluated more efficiently than with a centralized
      laboratory alone.





*(4)* **Obtaining
      regulatory approval and an industry accepted specification for our “e-diesel”
(ethanol-diesel) fuel:** As
      previously described in the Government Approvals section, the Company is
      continuing its efforts to certify its additives and O2Diesel TM blends
      under the requirements of the EPA, the CARB and the ASTM. Our progress with
      these certification requirements will support our efforts to develop an
      alternative fuel specification for the DoD. Obtaining each of these approvals
      is
      critical to successful commercialization of the Company’s products. The
      timeframe for obtaining these approvals has taken longer than anticipated,
      but
      the Company remains committed to finishing this process in the U.S. as well
      as
      its other global markets.




8





**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**





The
      Company has taken several steps since 2005 to overcome these problems and to
      support the introduction of O2Diesel TM fuel to
      new customer opportunities. First, we have assembled documentation regarding
      the
      design requirements of flame arrestors and equipment used in our markets to
      serve as a basis for a catalogue of flame arrestors and parts that can be used
      for a wide variety of engine/vehicle types and customer applications. We have
      identified several equipment vendors who we now work with so that needed
      equipment can be delivered to customer locations quickly and at competitive
      prices. To support these efforts further, 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. Second, we have developed
      a
      checklist of procedures to be used by our technicians (in conjunction with
      our
      customer) 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. In addition, we have developed a training program that will enable
      our
      technicians to teach our customers’ fleet maintenance staff about handling and
      storing O2Diesel TM fuel,
      fleet modification and maintenance issues that can be expected. Third, 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 continue to
      be
      evaluated.





All
      of
      these issues have led to greater lead times than expected to convert fleets
      from
      using regular diesel to O2Diesel TM .
      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. Other
      factors, such as the availability of the customer’s vehicles for conversion, the
      degree of participation provided by the customer’s maintenance employees and the
      flexibility provided to O2Diesel employees in assisting the implementation
      process (due to union, insurance or safety reasons) can all add to the length
      of
      time to accomplish these conversion tasks. The Company anticipates that the
      work
      completed since 2005 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.





Another
      challenge to our commercialization strategy in 2008 has been the price and
      availability of ethanol. The Company has seen that even with a reliable
      supplier, the price of this commodity 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 the price of competing products. For example, starting
      in the second quarter of 2006, many petroleum refiners began replacing methyl
      tertiary butyl ether (MTBE) in gasoline with ethanol. This replacement has
      caused the demand for ethanol to increase dramatically, with a corresponding
      increase in its price. Similarly, the demand for corn has increased
      significantly, since this commodity is the primary ingredient in the production
      of ethanol. In addition, since most ethanol is transported by rail, freight
      costs continue to play a larger role in its price, particularly when the end
      users are geographically distant from the production facilities. While
      production quantities of ethanol have continued to increase, the rise in its
      production and distribution costs have made the cost of O2Diesel TM increase
      in relation to conventional diesel fuel throughout 2007-2008. It is the
      Company’s strategy going forward to help control the costs of ethanol by
      continuing our contract with the ethanol industry group at preferred prices
      and
      continuing our efforts to acquire production capacity from projects like the
      ProEco acquisition and the strategic relationship with KL.





These
      challenges have presented significant hurdles to commercializing our technology.
      In many 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 in the U.S.,
      Europe, and other markets. We have been encouraged to see a port facility and
      a
      municipal bus fleet that have been successfully utilizing the fuel for
      approximately three years. Even with this technical knowledge, we will need
      to
      continue to refine our efforts in this area as well as attain the appropriate
      regulatory certification in order to bring on greater numbers of customers
      and
      to better predict the cost and timing of work required to have fleets conform
      to
      the requirements of using our product.





**Second
      Quarter Summary (three months ended June 30, 2008 compared to three months
      ended
      June 30, 2007)**





Operating
      results for the three month period ended June 30, 2008 showed significant
      improvement compared to results during the three month period ended June 30,
      2007. Although revenues and
      gross margin were
      approximately $12,000 lower in the current quarter, expenses have been reduced
      dramatically from the prior year’s level. Selling
      and marketing expenses for the
      three months ended June 30, 2008 decreased $203,000 compared to the period
      ended
      June 30, 2007 as CityHome projects were scaled back or cancelled and travel
      costs were reduced. Product
      testing and government grant expenses (net) in
      the three months ended June 30, 2008 were approximately $11,000 higher than
      in
      the comparable period ended June 30, 2007 due to a slight increase in research
      and development costs in the U.S. and Spain. General
      and administrative expenses for the
      three months ended June 30, 2008 were approximately $643,000 lower than for
      the
      three months ended June 30, 2007 primarily due to personnel reductions of
      approximately $145,000, lower
      professional fees of $387,000 (including $164,000 related to the settlement
      of
      legal and consulting fees) and $42,000 in reduced travel costs. In addition,
      general and administrative costs reflected a decrease of $87,000 in the
      recognition of share-based compensation expense required by SFAS 123(R) versus
      the same period in 2007.




9


**O2Diesel
        Corporation**
 **(A
        Development Stage Company)**
 **June
        30, 2008**




**First
      Half Summary (six months ended June 30, 2008 compared to six months ended June
      30, 2007)**





Operating
      results for the six month period ended June 30, 2008 showed significant
      improvement, compared to results during the six month period ended June 30,
      2007, largely due to overhead cost reductions. Revenues were
      approximately $181,000 lower in the first half of 2008, and the gross margin
      was
      approximately $123,000 lower, largely due to the absence of shipments to
      Energenics. Selling
      and marketing expenses for the
      six month period ended June 30, 2008 were $279,000 lower than during the
      comparable period ended June 30, 2007 as CityHome projects were scaled back
      or
      cancelled and travel costs were reduced. Product
      testing and government grant expenses (net) in
      the six months ended June 30, 2008 were approximately $118,000 lower than in
      the
      comparable period ended June 30, 2007 as $158,000 in reduced research and
      development spending in the U.S. (net of government contract reimbursements)
      was
      offset by $39,000 of increased spending on product demonstrations in Spain. General
      and administrative expenses for the
      six months ended June 30, 2008 were approximately $1.4 million lower than for
      the six months ended June 30, 2007 primarily due to personnel reductions of
      approximately $469,000, lower professional fees of $606,000 (including $164,000
      related to the settlement of legal and consulting fees) and $75,000 in reduced
      travel costs. In addition, general and administrative costs reflected a decrease
      of $174,000 in the recognition of share-based compensation expense required
      by
      SFAS 123(R) versus the same period in 2007.





**Cash
      Requirements and Liquidity**





To
      date,
      we have not had any bank trade facilities, except an overdraft line in the
      U.K.
      used to meet operating needs and a small vehicle loan, both of which have been
      repaid and canceled prior to 2007. 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.





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





On
      July 17, 2006, the Company received a letter from the AMEX indicating that
      the Company has regained compliance with AMEX listing requirements. The Company
      remained in compliance with the AMEX listing standards as of December 31,
      2006. However, for the quarter ended March 31, 2007, the Company did not
      meet the listing standards with regard to the need to have stockholders’ equity
      of $6.0 million. As more fully described above in the “Listing of Common Stock
      on AMEX” section, the Company has remained out of compliance with this
      requirement. On April 21, 2008, the Company received notice from AMEX
      indicating its determination to initiate delisting proceedings and on
      April 28, 2008, the Company announced that it began trading on the Over the
      Counter Bulletin Board under the trading symbol OTOD. Based on our projected
      level of expenses and the cash on hand as shown on our consolidated balance
      sheet at June 30, 2008, we will need to raise additional funds in 2008 to allow
      us to execute our business plan.





As
      a
      result of the lack of a sales history for our products, we do 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 will need to be raised.  During the second half of
      2008 we will need to raise additional equity.





The
      Company has undertaken a number of efforts to address its short-term liquidity
      challenges.  We have pursued new funding initiatives with the KL
      transaction.  We have engaged in renegotiations with Energenics Holdings to
      complete this transaction.  The work under our government contracts has
      continued, which provides funds for Company projects with the military and
      our
      efforts to obtain regulatory approvals.  We have taken a variety of cost
      control actions which have allowed us to reduce our overhead expenses by nearly
      40% when compared to the second quarter of 2007 and year-to-date figures. 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 investments, there can be no assurance that we will
      be
      successful in doing so.  In addition, there be no assurance that the
      Company will generate sales and sponsorship fees followed by the collection
      of
      cash to offset our operating expenses.


10


**O2Diesel
        Corporation**
 **(A
        Development Stage Company)**
 **June
        30, 2008**


As
      shown
      in the consolidated statements of operations contained in this report, we have
      generated only $6,579 in sales, and had sponsorship income of $0 associated
      with
      the CityHomeTM programs, for the three months ended June 30, 2008. As of the date
      of this report, we have only minimal orders on hand for either O2D05 or
      O2DieselTM, other than our supply requirements for Energenics  Lastly, there
      can be no assurance that actual events will not differ from those anticipated,
      or that general economic conditions may not vary significantly in ways that
      could negatively impact our operations and cash position.





**Research &
      Development**





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





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





We
      have
      registered a trademark in the U.S. and the European Union for a mark which
      includes the words and numbers O2Diesel TM as well
      as a figurative logo of the words. We also registered trademarks for “CityHome”
(and design) in four classes of goods and services, “CITYHO2ME” in two classes
      of goods and services and “TODAY’S CLEAN AIR SOLUTION TOMORROW’S BRIGHTER
      FUTURE” in one class of goods and services.





The
      Company has incurred substantial costs in carrying out tests to demonstrate
      that
      the use of our product will enable customers to comply with environmental laws
      and regulations. As of June 30, 2008, we incurred expenses of $275,080 during
      the first six months of  2008 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.





At
      the
      end of the second quarter of 2008, we have government test programs in progress
      with total remaining costs to complete of approximately $964,000. Under these
      programs a wide array of engine tests and product demonstrations are to be
      conducted to further prove the emissions benefits of O2Diesel TM and to
      show that the fuel performs well in specific applications.





Included
      in the foregoing programs is a product demonstration in Nevada to test a new
      fuel blend referred to as “O28”, which contains the Company’s proprietary
      additive, ethanol (8%), biodiesel (20%) and regular diesel fuel in non-tactical
      military equipment. Other programs underway include completing the protocols,
      emissions test verification and multimedia assessment to allow
      O2Diesel TM to be
      classified as a Diesel Emissions Control Strategy fuel by the CARB. 
O2Diesel has conducted demonstrations with a number of school bus and transit
      agencies which are evaluating the performance of O2Diesel TM as well
      as O28 for a variety of weather conditions, engine types, and operations.
      Related testing included using O2Diesel TM in large
      mining equipment as well as offering the military a clean burning diesel fuel
      for non combat vehicles that would satisfy Energy Policy Act and Presidential
      Executive Orders requirements for reducing foreign oil dependence. 
O2Diesel is currently working with the military to obtain a procurement
      specification for purchasing the fuel. Over the past two years, we initiated
      projects to develop the emissions test data necessary to register these fuels
      for on road application with the EPA.  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.





We
      are
      investing time and effort in the design and development of less expensive flame
      arrestor technology than what is in use today. This work is more labor intensive
      rather than capital intensive.  However, it is a key step in providing a
      turnkey solution to using these clean
      burning fuel options. Most of the design work has been performed by our own
      personnel and consultants with the actual fabrication work contracted out to
      specialized manufacturers. This work will continue during the second half of
      2008.




11


**O2Diesel
        Corporation**
 **(A
            Development Stage Company)**
 **June
            30, 2008**


In
      the
      second quarter of 2008, we did not conduct additional research and development
      projects in Brazil. However, we continued a fleet demonstration in Curitiba
      as a
      further effort to obtain approvals for O2Diesel TM from the
      agencies that are responsible for the country’s petroleum industry and
      environmental laws.





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





O2Diesel
      fuel has also become the first alternative fuel to be certified by the TECPAR’s
      national certification program Transporte Limpo (Clean Transport). For 2008,
      we
      do not anticipate spending significant funds on various product and vehicle
      tests in Brazil.





Similar
      to our efforts in Brazil, the Company also completed a demonstration for a
      municipal bus fleet in Anunción, Paraguay.





**Employees**





As
      of
      June 30, 2008, O2Diesel had twelve full-time employees, eleven of which are
      in the U.S. and one is in Europe. We had two temporary employees to support
      general administration. Currently, we rely on consultants to assist in
      commercializing our technology and to help us in key technical areas. At
      present, we employ six consultants in the U.S.; two in marketing and business
      development; one laboratory technician, one chemist; and two in regulatory
      affairs. The Company has entered into separate consulting contracts with two
      shareholders of its Brazilian subsidiary for the purpose of providing office
      rent and administrative services and in lieu of employment contracts with these
      two individuals. In Europe, we employ two consultants, one for general
      management and business development and one for regulatory affairs.





We
      will
      add new personnel in the second half of 2008 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 2008. We anticipate continuing
      to
      employ a total of eleven consultants serving in most of the same capacities
      in
      2008.





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





None.





**ITEM
      4. 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 Rules 13a-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.




12





**O2Diesel
      Corporation**


**(A
      Developmental Stage Company)**


**June
      30, 2008**





CHANGES
        IN INTERNAL CONTROLS OVER FINANCIAL REPORTING. On July 14, 2008, two
        directors who were members of the Audit Committee resigned from their positions
        on the Board. The internal control activities of the Audit Committee were
        carried out in a manner consistent with prior reporting periods up to the
        date
        of their resignation. To maintain good internal review procedures for financial
        reporting, the Company’s management requested that the Form 10-Q filing for the
        period ending June 30, 2008 be reviewed by the current board members, which
        included the remaining member of the Audit Committee. This was reviewed and
        discussed during a board meeting held on August 11, 2008. Aside from this
        change, 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
      1A. RISK FACTORS**





Not
      applicable to smaller reporting companies.





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





During
        the three months ended June 30, 2008, the Company issued 1,071,500 shares
        of
        restricted stock to two vendors in lieu of cash payments of $220,000 for
        investor relations services.





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





None.





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





None





**ITEM
      5. OTHER INFORMATION.**





None




13




**O2Diesel
      Corporation**


**(A
      Development Stage Company)**


**June
      30, 2008**





**ITEM
      6. EXHIBITS.**




The
      following exhibits are filed herewith.




**Description**10.1
            
            Amending and
              Restating
              Agreement, effective June 17, 2008 by and between O2Diesel Corporation
              and
              Energenics Holdings PTE LTD31.1
            
            Certifications
                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 200231.2
            
            Certifications
                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 200232.1
            
            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




**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, 2008
            By:
            /s/
                Alan RaeAlan
                RaeChief
                Executive Officer
              (Principal
                Executive Officer)




Date:
                August 14, 2008
            By:
            /s/
                David H. ShipmanDavid
                H. ShipmanChief
                Financial Officer
              (Principal
                Financial and Accounting Officer)




14